How to Know If You Have a Successful Business or Expensive Hobby

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Editor’s note: This is a guest post by Lisa Robbin Young.

When I started as a business coach over a decade ago, many of my first clients were excited about working with someone who could help them help grow their business into something that could impact the world. These creative entrepreneurs were generating revenue, and many were improving their lifestyles to match their new income. So, imagine their surprise when I informed them they didn't actually have a business. They had an expensive hobby.

They were working too hard for too little return. Most of their businesses were not profitable. The few who had plenty of revenue coming in had plenty more flowing out. Many had no formal legal structure or any of the necessary licenses, certifications, or insurance needed to conduct business in their area. Sadly, to more than a few, "profit" was only something they felt when their tax refund came back in early spring. I knew their problem well. I had encountered it in the early years of my entrepreneurial journey.

But that's not how you run a profitable, sustainable business.

I tell my clients to examine five areas to determine whether they have a successful business or expensive hobby: taxation, legal structure, finance, mindset, and interpersonal issues.

Once you assess those areas, you gain the clarity to decide which route is best for you. You can keep your work as a hobby, or you can take the necessary steps to build a legitimate business. Neither answer is right or wrong. You should do what’s right for you. However, confusing the two can be costly, sometimes resulting in lawsuits, fines, and other repercussions.

1. Businesses Are Taxed Differently than Hobbies

Every country treats business taxation in their own way, so please consult your national guidelines for specifics. Here in the U.S., there are a few "tests" the IRS applies to determine if you have a business or hobby. Why does its ruling matter? Well, if you have a hobby, you can only deduct expenses from the hobby income, not from all your income sources. A legitimate business may be able to deduct all expenses from any income source, including your day job or the income of your spouse.

That said, tread carefully before racking up a bunch of expenses year after year. If you have a loss too many years in a row, the IRS can disallow your business and consider it a hobby. Consult a tax professional or IRS Publication 535 to make sure you're in compliance. In the meantime, here are some of the more obvious tests applied by the IRS:

• Have you hired a coach or other business adviser? If you're actively employing a coach or consultant in your business, the IRS will acknowledge you're serious about the growth of the company. You probably wouldn't employ that kind of help if it were just a hobby. There'd be no need. But the fact that you're willing to hire a business coach can give your company more legitimacy in the IRS’s eyes.

• Are you keeping detailed records? Income and expenses are the tip of the paperwork iceberg in business. Detailed employment records, mileage logs, and business plans provide ongoing evidence to an auditor that yes, you are running a legitimate business. Documenting your growth or marketing plans in lieu of a full-blown business plan will satisfy most auditors. Having those guiding documents lets auditors know you're serious about growing your business and turning a profit.

• Have you made a profit? It’s not uncommon for an entrepreneur to have more expenses than income in the early business stages. If you’ve still got a day job, it’s also tempting to keep expenses high in order to reduce your taxable income and maybe see a bigger refund come tax time. But too many years operating at a loss makes it more likely that the IRS will disavow your business, meaning they consider your enterprise a hobby and tax it as such. The aim of a legitimate business is to turn a profit. The IRS likes to see you make money because then you pay taxes on that income. Even if it's just a few dollars, profit is an important consideration of legitimacy in the eyes of the IRS.

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2. A Business Is a Legal Entity, a Hobby Is not

Amateur brain surgery, anyone? You probably know that doctors and lawyers need a license to practice, but so do many home-based operations here in the United States. If you don't have an official business structure, the appropriate licenses, or local clearances to conduct business, then you're running an expensive hobby. Even if you're making a profit right now, the costs of getting "found out" could ruin your business. In Canada, unregistered businesses get shut down and fined. In some places in the U.S. you can be banned from ever running a business in that area again! You also open yourself to personal lawsuits if your clients decide to sue. (Hey, it happens!) They have a better chance of winning, too, since your business wasn’t set up properly.

Register your business as a legal entity, even if it's a sole-proprietorship under your own name. Pay your local municipalities the appropriate fees for licenses or certifications required to conduct your business in their location. Keep your personal funds segregated from business activities. Check with your government agencies (local, state, and national) to make sure your business is in compliance with any regulations that might apply. Failure to do so may force you to find a new location for your business.

Also remember you may need to pay municipal business taxes like sales and property taxes. You should pay these taxes not only because it’s right but also because they afford certain legal protections. For example, registering your business with the government often prevents other companies in your area from operating a business using your company name. It can also help you establish ownership of intellectual property rights like copyright, trademarks, and patents.

3. Business Finances Need Special Attention

Some creative entrepreneurs don't monitor their numbers on a regular basis. In her book, Put On Your Crown, Queen Latifah recalls the advice Oprah gave her after a financial mistake cost her thousands:

"Always sign the checks."

Sure, have a business manager, accountant, or financial planner (or all three). But make sure you know what's going on in the company. If you don't, you can't make empowered decisions. In which case, you've got a hobby, not a real business. And in Latifah's case, it was a very expensive mistake.

Unlike Billy Joel, who sued his former business manager to the tune of $90M for embezzlement and fraud, Latifah's mistake was not paying attention to how fast the money was going out. Her team was spending faster than she was bringing it in. When the tax bill came, she was almost broke. She learned her lesson and started giving consistent attention to her money, which stabilized things and helped her business continue to grow.

Whether it's financial numbers or business metrics (which, ultimately translate into financial numbers), a business owner keeps their finger on the pulse of what's happening. Otherwise, it's a hobby — and probably an expensive one at that.

4. Business Owners Need to Master Their Mindset

"I don't feel like it" can be the death knell for business. While I'm all for trusting flow and honoring intuition, there are times when we need to stay the course through the hard stuff to see a real breakthrough. If you get bored easily or don't want to do the necessary work to maintain the business, you may need some support to help you keep your business from turning into a hobby.

In The History Of The Eagles, Volume One, Glenn Frey recounts the day he confronted Randy Meisner, the lead singer for "Take It To The Limit." Meisner was tired of singing that song during their shows. Frey told him:

"Do you think I like singing 'Take It Easy' and 'Peaceful Easy Feeling' every night? I’m tired of those songs. But there’s people in the audience who’ve been waiting YEARS to see us do those songs."

Frey was a business owner, Meisner was a hobbyist. When it wasn't fun, Meisner wanted out. Frey focused on serving the needs of his customer. He understood that you’ve sometimes got to do things you don't enjoy because they're healthy for the business.

That mindset — to do what's right for the business even when we don't feel like it — keeps a business going. That's not the same as doing something that's not healthy for you. Frey finally suggested Meisner quit the band if he really didn't want to sing his songs anymore. Meisner quit the band in 1977, citing exhaustion.

That's the other side of business: you have to be willing to accept the consequences of the choices you make to achieve your dream. That's not to say you can't delegate some decisions and empower your team to decide on behalf of the company. You absolutely can. But some decisions need to stay in the business owner's realm. If you're looking for someone else to make those key decisions for you, you ain't got a business; you’ve got a hobby.

5. Businesses Must Consider Interpersonal Issues

While we don't often consider the emotional or social ramifications of a business, people with ego-driven businesses seem to have something to prove, and it's rarely about having a profitable, sustainable business.

Ego-driven businesses put the fantasies of the owner ahead of the needs of their clients. When ego takes over, you could end up creating something because you want it, not because the market wants it. That was the case with Jim Henson’s Labyrinth. The financial failure put him in an emotional tailspin. It was the last film he ever directed. Thomas Edison learned this lesson when he spent years developing an unprofitable product. He then vowed to never make a product that didn’t have a clear market ready for it.

Your ego could also pressure you to buy fancy equipment, "the best" of everything in order to impress yourself or others. This behavior is as detrimental to your company as pushing your team to work until they collapse (even if you're only a team of one). Neither is the sign of a healthy business. You just have an expensive hobby that could cost you your wellbeing as well as your cash.

It takes people to run a profitable, sustainable business, and those people need care and consideration. They are not cogs in a machine. Business owners can't just run roughshod over their teams anymore. Real businesses understand this dynamic and are willing to take their blinders off to respond to it. You're still the decision maker, but now you're making decisions from a place of service, not one of ego.

There Is No Wrong Answer — the Choice Is Personal

Whether you decide to run a legitimate business or to keep running things as a hobby, it’s important to understand the ramifications of that decision.

Hobbies are personal. They’re all about you. A business, even a not-for-profit one, serves an audience. When you look at your motivations without judgment, where does your work land? Do you care more about getting your way, or getting out of your way to serve employees and customers? (Tweet this.)

If you can answer those questions, you can see more clearly what’s going to work for you. And if it’s the business route, make sure you’ve done the work to keep it legit.