What’s the difference between a hobby and a business? A business operates to make a profit. While hobby activity may result in some income, people engage in a hobby primarily for enjoyment or recreation, not to make a profit.
Expenses incurred by for-profit business activities are generally tax deductible, hobby expenses are not. Hobby income, however, is still taxable. These circumstances lead some individuals to wonder if their personal hobbies can be considered businesses with a profit motive in order to obtain more favorable tax outcomes.
In recent years, more and more taxpayers are reporting secondary income from sources such as entrepreneurial businesses. In 2022, 44% of Americans reported engaging in a “side job” to help them make ends meet.
If a business is a secondary source of income, it is important to clearly distinguish it from a hobby activity. In addition to the intention to make a profit, there are other considerations that come into play to help make the case to the IRS that the activity is a business rather than a hobby.
Safe Harbor Rule
The IRS safe harbor rule indicates that if the business was profitable in at least three of the previous five consecutive years, the IRS will accept that it is engaged for profit. However, for industries such as horse training, breeding or racing, this rule may be extended to a profit in two of the prior seven years, because these endeavors involve a greater amount of risk.
“Treat It Like a Business”
Beyond the Safe Harbor Rule, taxpayers can increase their chances of prevailing against an IRS challenge by treating their activities like businesses rather than hobbies. This is especially important if a business is showing a loss rather than a profit. Ways of treating the activity as a business may include:
• Having a business plan
• Performing market studies
• Advertising
• Having separate books and bank accounts
• Conducting periodic financial reviews
• Employing expert advice or services
• Modifying business operations to improve profitability.
Common pitfalls for taxpayers to avoid include:
• Failing to keep records of revenues and expenses;
• Using personal bank accounts to pay expenses
• Deducting personal expenses not related to business activities
These considerations can be helpful in making the case for a business even with recurring losses.
Other Factors
Other factors are also used by the IRS in determining if an activity is a business engaged for profit. No one factor alone is decisive, and their relative importance depends on the case. These factors include:
• The manner in which the books and records are maintained
• The expertise of the business owner or advisors, including education or past experience in the type of business.
• The amount of time and effort put into the business
• The dependence on the income for livelihood
• The normalcy of the losses given the industry or uncontrollable circumstances such as fires, natural disasters or economic downturns
• The success in making a profit in similar activities in the past
• The expectation of future profit from the appreciation of the assets used in the activity
Hobby Income
According to the IRS rules, income of more than $400 in a calendar year from a hobby, must be reported as self-employed income. This income is reported on Schedule SE and is subject to self-employment tax.
Whether an activity is a hobby or a business, a CPA can help evaluate the issues and set up the planning and documentation needed for the most advantageous tax outcome.
If you have questions about this featured topic or other accounting and tax related topics, please do not hesitate to contact us at 727-327-1999 OR [email protected].
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