With today's gig economy, more individuals with part-time or full-time jobs are discovering hobbies that can provide them with a side income. A hobby can operate like a mini-business, taking up a few hours of your time each week and also earning money.
A lot of us have a variety of hobbies that we enjoy. Your hobby might even be able to earn you some extra income. The question is, how do you know if your hobby is a business? Or can a business just be an expensive hobby?
You may face a particular risk if you run a side business and mostly derive your income from other sources (such as from your own business, employment, or investments). Under certain circumstances, this side business might not be considered a business at all by the IRS. It might be considered a hobby.
It's imperative to know the difference between a business and a hobby since a legitimate business can deduct its expenses and maybe take a loss if it isn't profitable. However, if the IRS considers your activity as a hobby, you cannot deduct expenses to offset other income.
Learn all about the difference between a business and a hobby in this guide.
Why the difference between a business vs. hobby matters
It is important to understand the difference between a business and a hobby. Let's start by learning how the IRS views these two concepts.
The income of a business can be offset by all ordinary and necessary expenses. Operating losses can be deducted against other income and even carried forward to offset income in future tax years.
Tax-deductible expenses and losses are only available for activities classified as trades or businesses. This is especially true when expenses are high and losses start piling up year after year. Because of this, the IRS pays attention to businesses that have suffered losses over several years. Some of these "businesses" may just be hobbies.
The limitations of hobby activities are greater. Prior to the Tax Cuts and Jobs Act (TCJA), you could itemize deductions for hobby expenses, but only up to the amount of hobby income you earned. The 2% adjusted gross income limitation applied to these and other miscellaneous deductions. From 2018, these miscellaneous "2%" deductions are no longer permissible, so hobby expenses are no longer deductible.
What’s the Difference Between a Hobby and a Business?
At first glance, a hobby that earns money might appear to be no different from a business. However, they have very distinct differences. A business expense is treated very differently by the IRS than a hobby expense.
IRS guidelines state that a business earns a profit, but a hobby does not.
Almost any income you earn must be reported as taxable income on your taxes. Expenses, however, are a different story.
Due to the changes to the Tax Cuts and Jobs Act (TCJA) in 2018, you can no longer deduct expenses related to your hobby. These hobby expenses used to be able to be deducted on a Schedule A when itemizing your deductions.
A business can deduct expenses that are ordinary and necessary to operate. In addition, a net loss can be used to offset other income, including wages, interest, and dividends. Therefore, if a sole proprietorship files a Schedule C with their Form 1040, and the sole proprietor shows a loss on Schedule C, that loss can be used to offset other income earned.
How To Tell If You Have a Business or a Hobby
The question is, when does a hobby become a business? In general, the IRS classifies an activity as a business if it has a "profit motive." If you haven't made a profit in three of the past five years, you may have to prove that you have a profit motive and that any losses occurred as a result of circumstances beyond your control.
Taxation distinguishes between legitimate businesses and hobby activities. A business is considered a for-profit entity, while a hobby is considered a not-for-profit activity. The IRS defines a legitimate business as one whose primary purpose is "income or profit", an activity that is conducted "continuously and regularly."
IRS Nine Factors Test
When it comes to determining if an activity is a legitimate business or a hobby, the IRS looks at nine factors, and each case is considered on its own merits:
- Are you keeping good business records, maintaining a business bank account, and managing your business professionally?
- How much time and effort do you put into marketing and other activities to attract customers?
- Is this your primary source of income?
- Is your business losing money because of circumstances beyond your control or because of normal startup losses?
- Are you making changes to your operations to increase profitability?
- Are you hiring competent business advisors and possessing business expertise?
- Have you operated similar businesses successfully in the past?
- How much profit do you make each year?
- How likely is it that you will make a profit in the future?
Income that is more likely to be a hobby is scrutinized more closely by the IRS. Among these activities are fishing, craft sales, dog breeding, horse racing, photography, and writing.
Business vs. Hobby Rules for Business Types
The business-versus-hobby rules apply to sole proprietorships, partnerships, and limited liability companies (LLCs). The profits and losses of S corporations are included in their owners' personal tax returns, so hobby loss rules apply to S corp owners. Corporations are separate legal entities, so hobby loss rules don't apply.
What is a Hobby Business?
The word "hobby business" refers to businesses that are typically run from home and are based on semi-recreational activities that are interesting to the owner. There are as many types of hobby businesses as there are types of hobbies.
Hobby or sideline businesses are often labors of love rather than reliable sources of income. Most often this occurs when a business owner or freelancer has another source of income - such as a full-time job or an employed spouse - that effectively underwrites the microbusiness.
When does my hobby become a business?
If you started as a hobby, but now you want to turn it into a business, what should you do? There are criteria laid out by the IRS to help you. You should refer to the IRS Nine Factors Test above.
In addition to intending to run a business, you should make sure you operate it professionally and according to its criteria.
Can I still use tax deductions for my hobby?
No. According to the Tax Cuts and Jobs Act of 2017, miscellaneous itemized deductions cannot be deducted for tax years after 2017. This means hobby-related expenses cannot be deducted.
Before 2018, the IRS wouldn't allow you to claim losses if your activity was categorized as a hobby. You could deduct hobby expenses and itemized deductions on Schedule A, but only if they accounted for at least 2% of your adjusted gross income - that is, your gross income less adjustments to income. In addition, the amount of an expense claim cannot exceed the amount of income that you receive from your hobby.
How to Ensure You Have a Business
If you're concerned that the IRS will challenge whether your business is a legitimate one, there are steps you can take to secure your business. The IRS defines nine criteria regarding your business's profitability and the way you conduct your business.
Listed below are some steps you can take to improve your profit and run your business professionally. This process involves:
Maintain accurate records: Bookkeeping should be done by business owners in an organized manner. Be sure to send out formal invoices, handle bank reconciliations on a monthly basis, keep track of profits, and register transactions accurately.
Keep your business account and credit cards separate: Maintaining a business bank account and keeping your funds separate from your personal funds will boost your professional credibility. You will also be able to keep accurate books and records, which will be helpful come tax season.
Make sure you have the proper licenses and certifications: If you want to appear professional, get the necessary licenses and certifications to show that you're running your business professionally, not like a hobby.
Examine your business performance regularly: Are there ways you can improve how you make a profit? For instance, you might think about investing in a new marketing campaign or negotiating a better deal with your supplier. Be sure to document how you are improving profitability and operations.
Keep learning: There is a lot to learn when starting a business, so document any steps you take to improve your skills and grow your business knowledge.
Establish a small business plan: Set aside time to prepare and update your business plan. You don't have to spend hours on it, but focus on how your business will make a profit, when it will become profitable, and what you will do in order to achieve that.
Keep track of your working hours: To show that you're truly working on your business, make sure you track how much time you spend on it, especially if you're also working another full-time job during the day.
Be sure to document these steps thoroughly and treat your business like one. The IRS could disallow your business expenses and recalculate your tax liability if it challenges you and determines that your activity is a hobby.
How many years of losses can I have before the IRS declares my business a hobby?
It is presumed by the IRS that a business is in operation if it has earned a profit in at least three of the last five years. However, what if it hasn't? Your business situation can be reviewed by the IRS, and it can determine whether it's for-profit or not.
Another factor to consider is whether you operate in a business-like manner, if you do marketing and promotion to boost sales, and whether you rely on profits for your livelihood. Situations are assessed individually.
Turn to Your Local CPA
Almost every city requires local businesses to register for taxes. Although you may not plan to claim federal or state tax deductions for your hobby business, this rule applies to all money-making activities. You'll also need a "seller's permit" if you sell goods (such as homemade jewelry).
Microbusinesses, which are so tiny that the word "business" seems excessive, may be able to fly under the radar of these agencies in practice. Keep in mind, however, that if you do business without the licenses or permits required by your state or local government, you could be penalized. You may be fined, as well as paying any back taxes due.
According to the IRS, there is an estimated $30 billion in unpaid taxes each year, and incorrectly deducting hobby expenses contributes to that.
You should work with a local CPA to ensure that your tax return accurately reflects your activities. Besides helping you minimize your tax bill, he or she can also help you achieve your other financial planning goals.
Consult your CPA for any financial questions you may have.
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