The surest way to reduce your taxes is to convert personal expenditures into allowable deductions. Turn even a hobby into a business and you’ll cut your tax bill.

The No. 1 way to reduce your taxes with a smile is to convert your personal expenditures into allowable deductions. It sounds tricky, but it may not be so difficult as you think.

Here’s how you do it: Turn yourself into a business owner. This is not complicated, expensive or difficult to do, and incorporation is not necessary.

Establishing a "profit motive" is the key. To be in business, you merely declare it. And by doing so, you can magically turn personal expenses into tax deductions. If you want to operate in a noncorporate format, as an individual proprietorship, but under a different name than your own, no problem. It’s easy.

In some states, you may have to file a "DBA" (doing business as) form with your local county clerk. Basically, you just fill out a form with your name, address and the assumed name under which you’re doing business. For example, I might be "Jeff A. Schnepper DBA Super Tax Savings Associates."

Here’s the best part: Your business doesn’t have to make a profit for your expenses to be deductible. All you have to do is establish a "profit motive." Under the Internal Revenue Code, a "profit motive" is presumed if you earn any net income in any three out of five business years.

It’s recognized and expected that new businesses probably won’t make a profit in the early years. In fact, in the early years, you can insist that the IRS defer any challenge for the first five years as to the legitimacy of your business by filing Form 5213.

Remember you don’t have to show a profit — just a "profit motive." In one case, despite 20 years of losses, the court found a profit objective and allowed the deduction of business losses in full for one company. The case was not unusual.

The test for deductibility is whether you have an actual and honest profit objective. You need not have a reasonable expectation of a profit. While the Tax Court requires a primary or dominant profit motive, the U.S. Claims Court has held that having a reasonable chance to make a profit, apart from tax considerations, will suffice.

The test is subjective: Was your intent to earn a profit? The IRS looks at the following factors to decide if your intentions are honorable:

  • The manner in which you carry on the activity.
  • Your expertise and the expertise of your advisers.
  • The time and effort you expend in carrying out this activity.
  • The expectation that the assets used in your business may appreciate in value.
  • Your success in carrying on similar or dissimilar activities.
  • Your history of income and losses with respect to the activity.
  • The amount of occasional profits, if any, that are earned.
  • Your financial status.
  • The elements of personal pleasure and recreation. That doesn’t mean that just because you enjoy doing your "job" that the expenses aren’t tax-deductible. The Tax Court has ruled that "suffering has never been made a prerequisite for deductibility."

Moreover, even if you’re employed full time elsewhere, that doesn’t prevent you from having another vocation on the side. I spent many years as a full-time college professor while running a legal and accounting practice on the side. This technique works whether your business is your primary source of income or it’s a sideline.

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 have to necessarily 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 activity 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.