Hi there! I wanted to weigh in as our colleague Holly's suggestions to you were right on the money!!
I did want to mention to you - to assist you in putting the 2021 tax year business loss into proper context - that - typically, if a small business continues to run at a loss (meaning expenses are higher than income repeatedly) the IRS will become interested within 3 - 5 years.
When they do, the business may get reclassified as a hobby if the business owner can't prove he is really trying to make a profit.
Earning a profit
The IRS expects that if you start a business, you intend to make money at it. If you don't, your business might be a hobby. To determine if your business is a hobby, the IRS looks at numerous factors, including the following:
- Do you put in the necessary time and effort to turn a profit?
- Have you made a profit in this activity in the past, or can you expect to make one in the future?
- Do you have the necessary knowledge to succeed in this field?
- Do you depend on income from this activity?
- Are your losses beyond your control?
Practical standard for business classification
The IRS safe harbor rule is that if you have turned a profit in at least three of five consecutive years, the IRS will presume that you are engaged in it for profit. This may be extended to a profit in two of the prior seven years in the specific case of horse training, breeding or racing. This is, presumably, because these endeavors involve a great amount of risk.
Consequences of hobby classification
Generally, the IRS classifies your business as a hobby, it won't allow you to deduct any expenses or take any loss for it on your tax return.
If you have a hobby loss expense that you could otherwise claim as a personal expense, such as the home mortgage deduction, you can claim those expenses in full.
For tax years prior to 2018, other expenses, such as advertising, wages, insurance premiums, depreciation or amortization, may also be usable as an miscellaneous itemized deduction subject to 2 percent of your adjusted gross income. However, you must have earned more total income in your hobby than the amount of all of these deductions, including your personal deductions. In that scenario, it's likely the IRS would categorize your hobby as a business anyway.
Beginning in 2018, miscellaneous itemized deductions are no longer deductible and therefore no hobby expense is able to reduce hobby income.
Preventing your business from being classified as a hobby:
Running a hobby as a business could very possibly trigger an IRS audit. If your business is legitimate, keeping accurate and extensive records could help prevent the classification of your business as a hobby.
In addition to demonstrating your professional approach to your business, records and receipts can help document your profit motive. A written business plan is often a prerequisite for indicating an intent for profit, and it can also show ways in which you are modifying your business to cope with losses.
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