The ultimate tax shelter: Owning your own business

Your hobby can be a business

That means your hobby could qualify as a business. In the process, you'll cut your tax bill.

One of my clients raced stock cars as a hobby. When he came to me, we converted his "hobby" into a business. He had cards and stationery printed. He ran ads looking for a sponsor. He gave what once was his hobby the image and appearance of a business, and he demonstrated a real profit motive. He wanted to make money.

This client had a salary from his primary job of $40,000 a year. When his new business expenses were deducted, not only did he pay zero taxes, but he qualified for the earned income credit, so the IRS actually paid him.

Two years later, he was audited for that year's return. The law requires that you prove your business expenses, with receipts, checks or a journal that's regularly updated. Unfortunately, he had none of these for the first year. His expenses, however, were legitimate, and he had the receipts for the subsequent two years.

On the basis of the receipts for the two subsequent years not in question, this taxpayer with $40,000 in other income and no receipts, after an IRS audit, paid less than $100 in taxes, including penalties and interest.

Had he kept the records for the first year, he would have paid nothing.

How to qualify as a business deduction

To qualify as business deductions, your expenses must be:

• Ordinary and necessary -- defined by the courts and the IRS as "reasonable and customary."

• Paid or incurred during the taxable year.

• Connected with the conduct of a trade or business.

The term "reasonable and customary" depends on your specific business and the business customs in your locale. The expenses don't necessarily have to be reasonable and customary to you, but simply to your particular trade or industry. There are innumerable cases of "hobbies" converted into "businesses" with expenses allowed.

In one case, a husband and wife produced, exhibited and sold their sculptured works. Their expenses were considered ordinary and necessary business expenses. In another case, a coal miner operated a kennel for bird dogs. For 11 consecutive years, he lost money. But the courts allowed the deductions and the losses because there was a profit objective.

In a more recent case, a high school teacher's golfing was declared an activity with a profit motive, so he could legally deduct what once was his "hobby."

Focus on your profit-making motive. Remember that it's not what you pay in taxes that counts, it's what you keep. Personally, I'm rooting for you to pay millions in taxes -- but not a penny more than the law requires.

Updated July 6, 2009

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