Inventing as a Hobby or Business for Tax Purposes
If the IRS considers inventing to be a hobby, you can only deduct inventing expenses from inventing income.
Hobbies are great! They’re relaxing, entertaining and can lower your blood pressure. But if the IRS considers inventing to be your inventing to be a hobby -- not your business -- your blood pressure may rise. That’s because a hobbyist can only deduct inventing expenses from inventing income. If there is no income, there’s no deduction. And an inventor in this position can’t carry over the deductions to use them in future years when income may be generated. The deductions are lost forever.
In summary, inventors who are deemed to be hobbyists are in the worst of all possible tax worlds. So, if you’re looking for a hobby, try stamp or coin collecting; but make inventing your business.
If you qualify as an inventing business, you’ll become one of the pampered pets of the tax code, receiving the best possible tax treatment. You can deduct inventing expenses from other income you earn, such as salary from your job or your spouse’s job or interest and investment income. This can be done even though you don’t expect to earn any money from inventing for many years. Moreover, the tax law gives inventors who are in business special treatment, making their tax situation even better than that of most businesspeople.
Qualifying as a Business
For IRS purposes, inventing (or any other activity) qualifies as a business if:
- your primary motive for inventing is to earn a profit, and
- you engage in inventing continuously and regularly over a substantial time period.
The IRS has established two tests to measure these factors. One is a simple mechanical test that asks whether you’ve earned a profit in three of the last five years. The other is a much more complex test based on whether you behave like a business.
Note that the IRS only applies these tests if your tax returns are audited. In other words, you may mistakenly presume that inventing is your business only to learn, four or five years later that the IRS has a different opinion. In that case, you would be disallowed any improper deductions made during those years and required to pay any miscalculated taxes and penalties.
You Must Have a Profit Motive
Inventing can’t qualify as a business unless you do it to earn a profit. Making a profit need not be your sole motive, but it should be your primary one. For example, you may engage in inventing to help mankind, to become famous, to advance technology or just because you enjoy it. This is all fine as long as you also want to make a profit. (In contrast, inventing is a hobby if you engage in it for reasons other than making a profit -- for example, to incur deductible expenses or just to have fun.)
If you’re like most inventors, you’re probably thinking to yourself right now: “Of course, I want to make a profit; why else would I bother working on an invention?” This may well be true, but the IRS can’t read your mind to see whether you want to earn a profit. And it certainly isn’t going to take your word for it. Instead, it looks to see whether you actually earn a profit, or whether you behave as if you want to earn a profit. If you never earn a profit or behave like you want to, the IRS will determine your inventing activities are a hobby; this is so even though you sincerely believe in your heart that you want to make money.
Moreover, don’t think that just because you’re working on a serious or important invention that the IRS will conclude you’re in business. For example, building a windpowered ethanol plant sounds like a very serious idea, but a tax court was not impressed enough to permit the business deduction. If you don’t earn profits or behave as if you want to, even serious inventing efforts will be deemed a hobby by the IRS.
Regardless of whether your invention is characterized as “serious” or “wacky,” you are in business for tax purposes if you earn profits or if you act like you really want to. Keep in mind that when it comes to earning money, trivial ideas can be just as lucrative as serious ones (maybe even better) -- the Hula Hoop and Frisbee both earned millions in profits.
Passing the 3-of-5 Profit Test
You usually don’t have to worry about the IRS labeling inventing as a hobby if you earn a profit from it in any three of the last five years. If your venture passes this test, the IRS must presume it is a business. This doesn’t mean the IRS can’t claim your venture is a hobby, but it shifts the burden to the IRS to prove it is a hobby. In practice, the IRS usually doesn’t attack ventures that pass the profit test unless it’s clear the numbers have been manipulated just to pass it.
You have a profit when the taxable income from an activity is more than the deductions for it. You don’t have to earn a big profit to satisfy this test and there is no set amount or percentage of profit you need to earn.
The presumption that you are in business applies to your third profitable year and extends to all later years within the five-year period beginning with your first profitable year.
Passing the Behavior Test
If, like so many inventors, you keep incurring losses and can’t satisfy the profit test, don’t worry; you can still show you’re running a business by passing the behavior test. Indeed, this is how most inventors show the IRS they are in business. Under this test, the IRS looks at the following “objective” factors to determine whether you are behaving like a real business.
Whether You Act Like a Business.
Among other things, acting like a business means you keep good books and other records and otherwise carry on your inventing activities in a businesslike manner.
People who are in business usually have some knowledge and skill relevant to the business. Thus, adequate expertise in the field of invention you’re interested in shows you’re in business. If you lack the necessary expertise, you should acquire it through study or by consulting with experts in the field.
The time and effort you spend on inventing.
The more time and effort you put into inventing, the more likely it will appear a business.
Your track record.
Having a track record of success in other businesses in the past -- whether or not related to inventing -- helps show your present inventing activities are a business.
Your history of profit and losses.
Even if you can’t satisfy the profit test, earning at least occasional profits helps show you’re in business. However, the IRS is aware that inventors often earn no profits for many years in expectation of a big payoff if and when their invention is perfected and commercialized.
The amount of any profits you earn.
Earning only small or occasional yearly profits while you have large losses and/or a large investment in an activity, tends to show a lack of a profit motive. On the other hand, earning a substantial profit one year after years of losses helps show you are in a business. After all, inventing is a highly speculative venture and inventors often earn little or nothing for many years in the hope of a big payday down the road.
Are you rich?
The IRS figures you likely have a profit motive and are running a real business if you don’t have a substantial income from sources other than inventing. After all, you’ll need to earn money from your inventions to survive. On the other hand, substantial income from sources other than inventing tends to show a lack of a profit motive (particularly if your losses from inventing generate substantial tax deductions). But this factor is not determinative by itself.
Are you having too much fun?
Finally, activities that are inherently fun or recreational are less likely to be engaged in for profit than those that are not fun. Although inventing may be pleasurable, it’s not so enjoyable that this factor should pose a problem for most inventors.
The first three factors listed above -- acting like a business, expertise and time and effort expended -- are by far the most important. Studies have shown that no taxpayer who has satisfied these factors has ever been found not to be in business.
Any inventor can satisfy these factors and pass the behavior test. This is so even though you don’t expect to earn any money from inventing for many years.