“You should sell those.” It’s a phrase many people have heard when showing someone their crafts. When does a hobby become a business? Is it when you first start selling your items? Is it when you first turn a profit? When can you start deducting expenses against the income?
While the IRS makes a distinction between a legitimate business and a hobby, it is often hard to determine when your business has crossed over that line. And Ultimately, it is the IRS, not the taxpayer, that determines if the business is legitimate and not a hobby under audit. Many legitimate businesses start out with a loss in their first few years, so profitability alone is not a factor in determining if you have a business. The IRS defines a business as having a primary purpose of income or profit and is actively engaged with continuity and regularity. In general, this means the IRS looks at nine factors to determine if the business is legitimate: 1. Did you keep accurate records? 2. Was the time and effort put into the business indicative of making a profit given the right circumstances? 3. Is the taxpayer is dependent on the income? 4. Are the losses incurred beyond the taxpayers control? 5. Does the taxpayer have a plan or method for conducting business and making changes to garner a profit? 6. Does the taxpayer have the skill set needed? 7. If a prior similar business was owned, did it make a profit? 8. Does the business have a profit in some years, if not all? 9. Is there the means to make a profit in the future? The IRS often employees the idea that a business will make a profit in at least three of the last five years, (or at least two of the last seven if the product is related to livestock). While this is not a rule, it is a good guideline to follow.
If your business falls outside of these generalizations, the IRS may consider it a hobby. A designation as a hobby does not exclude you from having to report the income on your return. This is usually done on the Other Income line of Form 1040. The hobby rules limit the method in which you can take deductions against the income. This is when the difference between a hobby and a business becomes important. A business can offset income with all ordinary and necessary expenses by deducting them against the income and can carry those losses back or forward to offset income in other tax years. Hobby expenses are limited to the amount of income you make, so you can never deduct additional losses. Furthermore, you must itemize on Schedule A to claim the losses. If your total hobby expenses, along with any other miscellaneous expense that fall into this category, are not more than two percent of your adjusted gross income, or you do not itemize deductions at all, you cannot claim the hobby expenses. There are 3 categories of deductions that your hobby expenses may fall into, and these deductions must be taken in the following order: 1. deductions you can take for personal as well as business activities are allowed in full (including those for home mortgage interest, taxes, and casualty losses). 2. deductions that don’t result in an adjustment to the basis of property are allowed next, but only to the extent that your gross income from the activity exceeds your deductions under the first category. 3. business deductions that decrease the basis of property are allowed last, but only to the extent that your gross income from the activity exceeds your deductions from the first 2 categories. Since the Tax Cuts and Jobs Act of 2017 was passed, the standard deduction will be taken by most taxpayers, and the hobby expenses deduction will no longer make sense for most.
Once a hobby qualifies to become a business, the taxpayer will likely declare it on their Schedule C. The net income from the business is then included on the individual's personal tax return and is subject to both income taxes and self-employment taxes. If your business is an LLC or partnership or S corporation, you would prepare a tax return for that business and take the resulting income over to your personal tax return. This also opens up the ability to deduct the business expenses directly against the income. As many Schedule Cs are subject to higher scrutiny by the IRS, especially in the early years, it is critical to maintain detailed records outlining your efforts in advertising, meetings, trying to obtain income or sell services, mileage logs and work logs. As there are no concrete rules for determining when your hobby becomes a business, only that a business must actively be trying to make a profit, you need to effectively show every effort is being made.
In a nutshell, the difference between a business and a hobby comes down to how expenses/losses are treated, as income is always reportable. Business expenses and losses are fully deductible, while the expenses related to a hobby are only deductible up to the amount of any income you earned from your hobby. Much of the confusion for taxpayers occurs when they classify their hobby as a small business because it generates some income, and then take full deductions against the income for expenses. The IRS’s enforcement of hobby loss rules means if you truly are operating a business, you need to treat it like a business, and be prepared to prove your claim to an IRS representative. The first few years are always the hardest, while the business is finding its feet and are also the most reviewed by the IRS. So, while a loss in the first few years is not going to delegitimize your business, you must prove your methods and the validity of your business if under audit. Be sure to record accurate and complete accounting records. Be sure to comply with all federal and state business laws by ensuring you have proper permits, insurance, licenses and tax reporting numbers. Have a marketing plan and act on it – get business cards, print brochures, run ads in local papers. Growing enough revenue to ensure a profit over and above your expenses is a gradual process. Make sure that you do it right from the start and can prove to the IRS it is a real business and not a hobby.