Activities that involve an element of personal enrichment or recreation are magnets for IRS scrutiny. This does not necessarily mean that you cannot deduct expenses for an activity you enjoy; but in order to maximize your deductions you must be prepared to show that the activity is a business from which you intend to make money. You do not actually have to make a profit, but you do have to be able to show that you have a profit motive.

It’s not that the IRS is concerned one way or the other with your personal enrichment per se; instead, its focus is on the amount of money in its own coffers. Encouraging taxpayers to produce profits results in more revenue for the IRS. Activities enjoyed “merely” for emotional or spiritual or intellectual — rather than fiscal — improvement, on the other hand, are much more likely to produce expenses rather than profit. If all such expenses were deductible, it would actually result in decreased revenue to the IRS. Not surprisingly, then, the IRS does not hesitate to disallow deductions that it concludes result in “hobby losses.”

What does this hobby/business distinction mean to you? If the IRS determines that your activity is not profit-driven, your deductions will be limited to the amount of income the activity generates. That means you cannot use a loss from that activity to offset other income, such as salary or investments, so your extra expenses bring you no tax benefit. In order to have a usable loss, it is important that you be able to satisfy the IRS that the activity was indeed established with the intention of making a profit. Furthermore, treating a business as a hobby can be tax-costly in other ways–because hobby expenses are limited by the 2% of AGI threshold and because they can effectively reduce the value of some of your other deductions.

In order to make sure you are properly claiming all of the deductions available to you, and to shore up your position in the event of an IRS audit, it’s important to review this matter now rather than later. Converting personal expenses into business expenses by properly establishing your activity as a business can usually be accomplished–but delaying the project can lead to lost tax savings and a hefty tax bill in the event of an IRS audit.