Hobby vs. business: When does a hobby become a business?
Alice bakes and sells fancy cupcakes.
Lou fixes small appliances and charges for his services.
Since they started their respective businesses about five years ago, each of their ventures have lost money or just barely covered expenses. The IRS could take notice of the business losses that each of them has been claiming on their tax returns and look more closely.
Is one of these activities a business vs. hobby? The answer is that in the tax world, the IRS could classify any activity as a hobby or, more precisely, as a not-for-profit activity. But where’s the line in the sand, so to speak? Discover more insights as we answer, “is my business a hobby?”
Why the difference between a business vs. hobby matters
The difference between a business vs. hobby is important to understand. First, let’s cover how the IRS views these two concepts.
A business can offset income with all ordinary and necessary expenses. Businesses can deduct operating losses against other income and even carry the losses forward to offset income in future tax years.
Expenses and losses are deductible only for activities classified as a trade or business. The difference is most profound when expenses are high, and losses start mounting up year after year. This is why the IRS pays attention to businesses with several years’ worth of losses. These “businesses” may just very well be hobbies.
Hobby activities come with more limitations. Prior to the Tax Cuts and Jobs Act (TCJA), you could deduct hobby expenses as itemized deductions, but only up to the amount of hobby income you made. These deductions, along with other miscellaneous deductions, were subject to 2% of adjusted gross income limitation. Starting in 2018, these miscellaneous “2%” deductions are not allowed, so hobby expenses are not deductible.
How to know when your hobby income becomes a business
So, when does a hobby become a business? The IRS will generally classify an activity as a business if it has a “profit motive.” Usually, the IRS assumes that if you’ve made a profit in three of the past five years, you have a “profit motive.” If you haven’t made a profit in three of the past five years, you may end up having to prove that you have a profit motive and that your business losses were due to circumstances beyond your control.
The IRS uses these nine factors to evaluate whether an activity is a business or hobby
Keep in mind that this is a simple summary and that the IRS applies each of these factors specifically for each person’s situation. For help with your unique tax situation, work with a Block Advisors small business certified tax pro.
- How do you carry on the activity – “businesslike” operations with detailed books and records, or more informally?
- What’s your level of expertise, or your advisor’s expertise, in the business or industry?
- How much time and effort do you spend on the activity?
- What’s your expectation that assets you use in the activity may appreciate in value?
- What financial successes have you had in other business activities?
- What’s your history of income or losses from the activity?
- How much in occasional profits do you earn, if any?
- What are your other income sources?
- Does the activity entail personal pleasure or recreation?
Not all factors apply to every situation, and no single factor determines the outcome. Ultimately, it comes down to whether you can prove you’re motivated and able to earn a profit. It’s not enough for you to want, hope, or intend to make money. You must show that it’s possible for you to earn a profit, given the nature of the activity and the way you handle it.
The type of activity, by itself, doesn’t reveal much about whether the IRS will see it as a business or a hobby. Remember the type of business, be it selling baked goods or repairing appliances by itself doesn’t indicate that you have a business. It’s if it’s profitable and the manner of how you conduct the business is what helps determine whether an activity is a business or a hobby.
Getting back to the business vs. hobby example
Getting back to Alice and Lou, do they have the skills, background, and time to devote to their respective enterprises? Do they keep excellent books and records? Have they figured out why they don’t make money, and can they change anything so that they start turning a profit?
Perhaps Alice needs to invest in different equipment, charge more money, or find better ways to market her baked goods.
Perhaps Lou has a full-time job and never meant for his repair activity to be anything but something to tinker with for fun and a little extra money to pay for tools that he was going to buy anyway.
Get help understanding hobby vs. business tax
Alice and Lou’s situations show you why it’s important to do your homework and get good advice before filing your tax returns. Block Advisors can help you determine whether you have a hobby vs. business and the tax implications.