You’re making some income selling your handmade jewelry…
Your cover band keeps booking paid gigs…
People are hiring you to photograph weddings or refinish antique furniture…
Are your business activities a hobby or a business? There is a difference at tax time, and you want to ensure you present your activities the right way.
The IRS defines a hobby as something you engage in “for sport or recreation, not to make a profit.” But making a profit alone does not make your hobby a business. Likewise, failing to generate revenue does not make your business a hobby.
Your intent is a deciding factor.
Hobby versus business matters because classifying your activity as a business ensures that you can write off certain expenses and decrease your tax burden.
On the flip side, if your business is a hobby, you can’t deduct your expenses, but you also do not have to pay self-employment tax.
So make sure you know how the IRS will interpret your business activities. In this post, I discuss:
- The difference between a hobby and a business.
- How the IRS makes its determination.
- Why a recent change means you can no longer deduct hobby expenses.
The difference between hobby and business
In determining whether your activity is a hobby or a business, the IRS will focus on intent rather than size or amount of business.
For example, one artist may sell one painting a year and qualify as a business. Meanwhile, another artist may sell eight paintings a year but remain a hobbyist in the IRS’s eyes.
Why?
Because the first artist has chosen to go into business with the intent of making a profit. As long as the second artist is painting for pleasure, without intending to generate income, they do not have a business.
How the classification impacts your taxes
Suppose an individual, partnership, estate, trust, or an S corporation engages in an activity not considered a for-profit business.
In this case, that entity can not deduct any expense other than the cost of goods sold. So there may be sales, marketing, and management expenses that the entity could not deduct.
However, individuals who work for themselves as businesses are subject to self-employment tax, which you do not have to pay if your activity is a hobby.
Note that the IRS assumes you intend to run a for-profit business if you form any corporation other than an S-Corp.
If you own a corporation or conduct your business in a way that the IRS considers “for-profit,” you get the benefit of deducting overhead costs and expenses related to running the business.
However, you may have to pay self-employment taxes.
So, do you have a business or a hobby?
These 9 questions will help you determine the answer.
These questions cover the factors that the IRS recommends that you consider when classifying your activity. Try to look at what you do objectively and answer each question with honesty.
Answering “yes” most of these questions will indicate that you likely have a business. Answering “no” suggests that you are a hobbyist.
Now the caveat: the IRS will take all facts and circumstances into account. No single aspect can make the determination, and this list is not all-inclusive. So this is indicative, but the IRS will make the final decision.
On to the questions…
1. Do you carry on the activity in a business-like manner?
Some sub-questions to help you define this are:
- Do you maintain complete and accurate books and records? (As a hobbyist, you must keep track of your earnings, so keeping track does not necessarily mean that you are a business. But if you want to show the IRS that you are operating a business, then keeping your books and records is very important).
- Do you operate in a very similar way to profitable activities of a similar nature?
- Do you change working methods and techniques to improve profitability?
2. Are you or your advisors experts in the field?
Having and using expertise suggests a level of knowledge that implies that you are running a business. So the key questions are:
- Are you knowledgeable or in consultation with those who are knowledgeable about a particular industry
- Do you use that knowledge to try to make a profit?
3. Do you expend a lot of time and effort?
The more effort you invest, the more your activity looks like a business.
Do you take away time from another occupation to do this work (if you reduce the time you spend on other employment or ventures, this indicates you see this as a business)?
Do you have employees (having employees is a pretty clear indicator that you are operating a business?
4. Do you expect that assets used in the activity may appreciate?
Even if you make no profit from operations, investing in land or other assets that appreciate and generate income implies running a business.
5. Have you been successful in carrying on other similar or dissimilar activities?
This, again, goes to establishing your expertise as a business owner.
6. Do you have a history of income or losses with respect to the activity?
Both startups and hobbies tend to lose money at some point in their evolution. So the IRS will look toward your history in dealing with these losses. If you have a history of making gains or turning losses into gains, this will support the idea that you are running a business.
Note that early losses during start-up or due to unforeseen circumstances beyond your control (such as disasters or theft) do not suggest that you are engaging in a hobby. Remember that the determination comes back to intent.
7. Did the activity make a profit, even a small one, in three of the last five years?
Occasional large profits mixed with frequent small losses or investing in future profits indicate a business motive.
8. Do you have no substantial income or capital from other sources?
If you have significant income from other sources, this supports the idea of you engaging in a hobby. If you rely on this activity for income, then it is much more likely a business.
9. Does the activity lack personal pleasure or recreational elements?
If the activity does not involve personal or recreational appeal, this could indicate a profit motive. In contrast, something you do for fun suggests more of a hobby.
If you found yourself answering “yes” to most of the above questions, your activity likely constitutes a business.
On the other hand, if you answered “no” to most of the questions, you probably operate as a hobby.
But also remember that this is not a black and white situation; the real question is your intent. No one “yes” makes you a business instead of a hobby; it is the entire package together that will support your claim one way or the other.
Can you reduce the chances of the IRS classifying your business as a hobby?
Most of our clients are more concerned about ensuring that their business is NOT considered a hobby. The value of the deductions generally exceeds the expense of self-employment taxes.
So how do you show that you are operating a business?
The first step in demonstrating that you are a legitimate business is to be one and work as one.
Establish your business structure and act like a business.
Beyond this, the IRS will look for evidence that you are actively trying to make money. You can demonstrate your professional approach in the following ways:
- keep accurate and detailed records, receipts, and documentation;
- open a separate bank account for your business, and avoid intermingling funds;
- write a business plan outlining how you intend to generate revenue;
- register as an LLC or partnership, and obtain and keep current all necessary federal, state, and local licenses and permits;
- create a professional website and marketing materials, such as business cards.
Doing these things will show the IRS that you are serious about turning a profit and that they should classify your activity as a business, not a hobby.
As an added benefit, these also happen to be good business practices in general.
What if your actions are a hobby?
The advantage of a hobby is that you don’t need to pay self-employment tax. So if what you do is genuinely a hobby, this classification will help you. You just report your hobby income as “other income” on your 1040 form.
Gross hobby income equals gross receipts minus the cost of goods sold.
In the past, taxpayers could deduct certain allowable “ordinary and necessary” hobby-related expenses. This itemized deduction applied up to the amount of earned income.
However, the Tax Cuts and Jobs Act eliminated all miscellaneous itemized deductions. That means that hobbyists now cannot deduct any expenses but still need to report and pay taxes on hobby-related income.
In closing…
Operating as a business allows you to deduct expenses and losses that you cannot as a hobbyist. Operating as a hobby limits your deductions but does allow you to avoid paying self-employment tax.
Getting this wrong can have serious implications, and whether you operate a business or a hobby is more complicated than whether or not you make a profit. It is about intent, which depends on interpretation.
Understanding how the IRS determines these classifications can save you from heavy penalties or even an audit… not to mention making your activity more successful and rewarding, whether it’s for business or pleasure.
Would you like some help?
If you are a client and would like to book a consultation, call us at +1 (212) 382-3939 or contact us here to set up a time.
If you aren’t a client, why not? We can take care of your accounting, bookkeeping, tax, and CFO needs so that you don’t have to worry about any of them. Interested? Contact us here to set up a no-obligation consultation.
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