Business vs. Hobby Income
For some activities, there’s a clear indication that it is a business. But what about when your hobbies result in a profit? This could be crafting, writing, illustrating, cooking, photography, etc. If you make a profit from a side project, it’s important to know whether the IRS classifies this activity as a hobby or a business.
The IRS determines whether you have a hobby or a business on a case-by-case basis. Typically, the classification comes down to intent and profit. A business has the intention of making a profit while a hobby is for sport or recreation. If you earned a profit in three of the past five years, the IRS will generally classify your activity as a business. But, there are other considerations that the IRS will look into.
IRS Considerations
If you’re wondering whether the IRS will consider your activity as a business or a hobby, you should ask yourself these nine questions:
Is the activity carried out in a businesslike manner with proper recordkeeping?
Have you put time and effort into the activity that shows intent for profit?
Do you depend on income from the activity for your livelihood?
Are losses from the activity due to circumstances beyond your control or normal for the startup phase?
Do you change methods of operation to improve profitability?
Do you have the knowledge to carry out the activity as a successful business?
Have you been successful in making a profit in a similar activity in the past?
Have you made a profit in some years?
Do you expect to make a future profit from this activity?
Answering yes to all these questions most likely implies that you have a business. If you’re unsure or answer no to some of these questions but consider your activity as a business, you should speak with a tax advisor. It’s important to know how to classify your activity because businesses and hobbies are reported differently on your tax return.
If you have a business...
How you file and what you need to report for a business depends on your business type. If you’re a sole proprietor, single-member LLC, or if you’re self-employed and receive a 1099-NEC, then you will need to file a Schedule C that details your income and expenses. You will also need to pay self-employment taxes on any business income you earn. For C Corporation and S Corporations, you will need to file a Form 1120 and 1120S, respectively.
As a business, you can deduct “ordinary and necessary” business expenses. This may include advertising, supplies, home office expenses, and other costs of running your business. It’s important that you keep complete and accurate documentation of everything you deduct as a business expense.
If you have a hobby...
You must report hobby income on Schedule 1 on your Form 1040 under Other Income. However, you cannot deduct any expenses or losses. The ability to deduct hobby expenses was ruled out beginning in 2018 with the Tax Cuts and Jobs Act (TCJA) of 2017.
If the IRS disagrees with your classification...
You may be audited if the IRS questions the classification of your activity, whether you claim it as a business or a hobby. They will look to see if you’ve made a profit in at least three of the past five years in addition to the nine factors mentioned earlier.
You can either agree with what the IRS says, which may involve amending your previous year's tax returns to properly report income and expenses from your activity. Incorrectly claiming a business instead of a hobby may mean losing deductions that you claimed as a business and owing taxes as a result. Meanwhile, claiming a hobby instead of a business may mean paying back taxes for self-employment. If you disagree with the IRS, you can appeal the decision and must provide supporting documentation.
Have questions about your hobby or business?
We recommend talking with a tax specialist if you have any questions regarding your hobby or business. If you’re looking for an experienced tax specialist, give Northside Tax Service a call at (360) 922-0235. We’d be happy to help
Disclaimer: This material is prepared for informational purposes only, and is not tax advice. Please speak with a tax professional or view the resources below to see how this information may apply to you.
