While the IRS gives a lot of weight to the 3-of-5 test, it is not conclusive. In other words, if you flunk the 3-of-5 test, you still may be able to prove that your business is motivated by profit. You can use virtually any kind of evidence to show that you're trying to make money.

Business cards, a well-maintained set of books, a separate business bank account, current business licenses and permits, and advertising or other marketing efforts will all help to persuade an IRS auditor that your activity really is a business.

Complying With Local Business Rules

Many cities require every local business to obtain a business license, or tax registration certificate. Technically, this rule applies to any money-making activity -- even if you don't intend to claim any federal or state tax deductions for your hobby business. Also, if you sell goods (such as homemade jewelry), your sales will be subject to state sales taxes, which means you'll have to apply for a "seller's permit."

In practice, many microbusinesses -- so tiny that the word "business" seems excessive -- might be able to fly under these agencies' radar. But be aware that, depending on your local rules, you could be penalized if you're caught doing business without the licenses or permits required by your state or local government. These penalties may include fines and any back taxes that apply.

In addition, getting the necessary licenses and permits will help show the IRS that you really are running a business. For more information, see 'Obtaining Licenses and Permits.