Hobby or business? This is something that is constantly asked in our Free Facebook Group so I knew it was time to do a Blog and Podcast episode for it. From a tax stand point, a hobby and business are taxed very differently so it’s important to know the difference between them.
What is a Hobby?
The IRS says a hobby is any activity that a person pursues because they enjoy it and with no intention of making a profit. This differs from those that operate a business with the intention of making a profit.
The IRS lists nine “factors” that they use in determining whether an activity is a hobby:
- Whether the activity is carried out in a business like manner and the taxpayer maintains complete and accurate books and records.
- Whether the time and effort the taxpayer puts into the activity show they intend to make it profitable.
- Whether they depend on income from the activity for their livelihood.
- Whether any losses are due to circumstances beyond the taxpayer’s control or are normal for the startup phase of their type of business.
- Whether they change methods of operation to improve profitability.
- Whether the taxpayer and their advisors have the knowledge needed to carry out the activity as a successful business.
- Whether the taxpayer was successful in making a profit in similar activities in the past.
- Whether the activity makes a profit in some years and how much profit it makes.
- Whether the taxpayers can expect to make a future profit from the appreciation of the assets used in the activity.
As long as you are profitable there is not many worries, however it is when you are not profitable that it matters.
What Are Hobby Loss Rules?
If an activity is considered a hobby by the IRS, losses from that activity may not be used to offset other income. Essentially deductions would not be able to exceed the gross receipts for that activity.
Now here is the kicker you take the deductions related to hobbies as a miscellaneous itemized deduction on Schedule A. However with the Tax Cuts and Jobs Act, they disallowed all miscellaneous itemized deductions that are subject to the 2 percent floor for tax years 2018 thru 2025.
This essentially means that if your activity is considered a hobby you will have to report any gross receipts from it as income but you will not be able to take expenses. So, more importantly, lets discuss how we can avoid your activity being considered a hobby.
How Can I Turn My “Hobby” Into a Business?
The IRS has a safe harbor option which states:
An activity is presumed carried on for profit (aka not hobby) if it produced a profit in at least 3 of the last 5 tax years, including the current year.
Knowing that, the first and easiest method to avoid hobby loss rules is to show a profit in at least three out of five consecutive years.
The second way is to run your activity in a way that shows you intend to turn it into a profitable business. What are ways you can do this?
- Meet the “Business Like Manner” Test
- Create a business plan
- Project revenue and expenses
- Use Xero or another accounting software to record revenue and expenses
- Save receipts and document business purpose (Who, Where, Why)
- Keep records of potential leads and your customers
- Have full financial statements (Income Statement and Balance Sheet)
- Seek Business Advice
- If you have a business that generates losses for multiple years the IRS expect that you would get business advice from those with knowledge and experience to help you become more profitable.
- Make sure you document that advice (handouts, notes, etc).
- This is typically going to be from third-party professionals (accountant, business coach, consultant, etc)
- Time and Effort
- Keep records of the time and effort you are putting into this activity.
- Time spent on learning, sales, advertising, administration, development, etc.
- Easiest way would be to keep a journal or timesheet detailing the work done on your venture.
Bottom line, you need to be able to prove a profit motive so make sure you are keeping that in mind as you are starting your new business. Be sure to document the things discussed to ensure you have proof to back up that you are running a business and it is not simply a hobby!