When Is Your Small Business Really a Hobby?

If you decide to run a business from your home, you better make sure you take it seriously or you could be facing a sticky tax situation.

One tax court case provides a textbook example of how not to operate a direct sales business. Brenda Konchar reported net losses for her Mary Kay direct sales “business” for several consecutive years. The IRS disallowed the losses, stating that the activity was a hobby and not a trade or business entered into for profit. Even if the activity had been conducted with a profit motive, most of the business expenses she claimed could not be substantiated.

The Tax Court agreed with the IRS that the activity was a hobby and not a business. Under §183(b), if an activity is not engaged in for profit, expenses are generally only deductible to the extent of the gross income from the activity. You can't deduct expenses in excess of your income.

The Court determined that the taxpayer did not intend to make a profit in her Mary Kay activity because:

  1. She did not conduct the activity as a business. She did not maintain a separate checking account or have business cards.
  2. The deduction for returns and allowances plus cost of goods sold exceeded her gross receipts, indicating that she was selling her products at or near cost.
  3. There was an element of personal pleasure in the activity, as most of her customers were family and friends. She took huge business mileage deductions for long distance travel to visit these customers for business and personal reasons.
  4. She had no experience in operating her own business and did not seek any professional advice.
  5. She claimed large losses each year and never developed a plan to improve the activity’s profitability.

It is very important to pass the “duck test” (if it walks like a duck and quacks like a duck, it is a duck) when it comes to operating a business as a direct seller of Mary Kay, Tupperware, Avon, etc. So, what should you do?

Firs, it couldn’t hurt to form an LLC for your business.

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