The line between a business venture and a hobby can be blurry at times. You may have a very profitable hobby or you may have a small business that has been in the red for several years. The distinction is an important one, though, when it comes to taxes.

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The IRS will allow you to deduct your full losses against business income and you can use that net loss to offset your other sources of income. If the taxman decides that you are engaging in a hobby, you may only deduct certain itemized deductions as per Schedule A. So how does the IRS label a venture either a business or a hobby? (If your business has hit a wall, we've got the answer to break through and increase sales and earnings. Check out 10 Breakout Ideas For Small Businesses.)

Time and Effort
Running a successful business takes both time and effort. The IRS looks at how much time you spend operating or planning for your business versus how much time you spend on other ventures. If you only spend a couple of hours on the weekend noodling around, the IRS is likely to determine that you have a hobby operation. If you are in the startup phases of a business, however, you may not yet have profit but you will be investing substantial amounts of time in planning, strategizing and promotion. Sometimes the distinction can become tricky.

Profit Potential
The IRS also looks at whether your business is likely to make money in the future. Your business doesn't have to make money every year, but it does have to be moving towards profitability. For example, if you raise show dogs and have some income from selling puppies, you will have expenses that will typically exceed the income you make. Running a show kennel can be expensive and may never show a profit. The IRS will deem this kind of operation to be a hobby.

Nature of Losses
There is an enduring tax myth that says that the IRS will only allow you to have business losses for a certain number of years (typically, three years is the benchmark used). The fact is that some businesses produce profits earlier than others and the IRS takes this into consideration. An author, for example, may have writing costs for three or more years before seeing any book revenues.

If you have had losses for a number of years, you do increase your chances of the IRS coming to have a closer look. They will examine the nature of the losses. Are they in the startup period? Are they in anticipation of larger revenues down the road? If your losses look more continuing and permanent, your business may be labeled a hobby. (Don't leave it up to your accountant - owners are ultimately responsible for fulfilling tax obligations. See Small Business Tax Obligations: Payroll Taxes.)

Dependence on Income
How much you rely on the revenues from your business also plays a part in deciding how to categorize your operations. If most of your expenses are mortgage interest - which you would be able to deduct anyway - then you are receiving cash income from your business. If that income forms a large part of your overall income, it is more likely that you are running a business and not just a hobby. A hobby's main intent is not to produce income.

Knowledge and Experience of Management
In a loss situation, the IRS may want to know more about whether you, and any managers you employ, know enough about running a business to be able to turn a profit eventually. They will look at your prior business experience and any training you have had in finance, marketing or operational management. If it doesn't appear that you know what you are doing or what it takes to turn the business around, the IRS may decide that it is not a legitimate business.

Strategic Alterations
If you do have the business acumen to analyze your company's red ink and have made changes to the forecasts or strategic direction of the business to achieve eventual profitability, the IRS will take that into account. They don't need to see immediate profits - only that you are moving towards profitability. (If an economic storm has your business taking on water, we provide tips for bailing yourself out. Check out Keeping A Small Business Afloat.)

The Bottom Line
Not all businesses make money in all years, especially in the beginning stages, and having that business loss to claim against other sources of income can help ease the financial pain. Make sure that your business follows the guidelines and stays out of hobby territory in order to make the best use of any losses that occur.

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