It seems like everyone has a side hustle these days, but is your side hustle a hobby or business? Even if you consider it a business, in the US, the IRS may not agree, (similar to the CRA’s stance in Canada). Knowing the distinction between business and hobby is important and getting it wrong may result in serious consequences. Whether you’re just trying to earn a little money on the side, diversify your income stream or turn your side hustle into a full-time gig, make sure you know how to avoid having your status challenged by the IRS.
Learning the IRS Rules
A trade or business can offset taxable income with “ordinary” and “necessary” business expenses. Ordinary means the expense is common and accepted in that industry. A necessary expense is one that is appropriate for the business. A sole proprietor who reports a net loss on Schedule C of Form 1040 can use that loss to offset other income, including wages, interest, dividends, etc.
If you earn income from a hobby (not an official business), that income must still be reported on Schedule C of your tax return, but expenses of the hobby cannot be netted against hobby income. Instead, hobby expenses are claimed as miscellaneous itemized deductions on Schedule A and your hobby expenses are limited to the amount of hobby income. In other words, your hobby business cannot generate a net loss.
A business that has been operating at a loss for several years runs the risk of being challenged by the IRS and having their tax liability recalculated under hobby loss rules.
Factors to Consider
In general, the IRS will consider the activity to be a business if you’ve made a profit in at least three of the last five years, but many businesses take some time to be profitable or go through downturns. Fortunately, there are other factors the IRS considers.
- Does the time and effort put into the business indicate an intention of making a profit?
- Do you depend on the income from the business?
- If there are losses, were they due to circumstances beyond your control or did they occur in the start-up phase of the business?
- Have you changed operation methods in order to improve profitability?
- Do you or your advisors have the knowledge and experience necessary to carry on a successful business?
- Have you earned a profit from similar endeavors in the past?
- Do you have a reasonable expectation of making a profit in the future?
- Is there a reasonable expectation that the assets used in your business will appreciate in value?
- Are there elements of personal pleasure or recreation in the activity?
Businesses with elements of personal pleasure or recreation face larger hurdles to overcoming hobby loss challenges. Horse-breeding, training, showing or racing businesses attract a lot of IRS attention because they are expensive and are often pursued as hobbies by wealthy individuals.
No one factor determines whether your activity is a business or hobby, but the more elements you have in your favor, the better off you’ll be if the IRS comes knocking.
How to Challenge-Proof Your Business
If you’re concerned about a hobby loss challenge, there are steps you can take to challenge-proof your business.
- Keep thorough business books and records, and use those records to review and improve performance.
- Maintain separate business bank accounts and credit cards.
- Have the proper business licenses, insurance, or certification for that type of business.
- Develop a written business plan and update it annually.
- Show a history of expertise in the business or attempts to develop expertise. Have you studied the industry, enrolled in classes or consulted with experts?
- If you are working another full-time job while you pursue the business, document the amount of time you spend working on your side hustle.
- If you are losing money, document your attempts to change direction and improve profitability.
Examples of Challenges Won
Many Tax Court cases have demonstrated how taxpayers can win against having their business losses challenged.
From 2004 to 2010, musician Thomas Gullion reported losses from his work as a musician totaling more than $130,000. Despite holding a full-time job as a computer programmer, Guillon was able to successfully convince the court that his musical activities were conducted with an honest objective to turn a profit.
Gullion played the saxophone since the age of eight, studied under well-known musicians and worked solely as a musician in Chicago from 1995 until 2002. Gullion testified that his losses were due to changes in the music business, with jazz clubs closing in Chicago, reducing the opportunity to make money. He made changes to his business, relocating to Wisconsin where the cost of living was lower and shifting his emphasis from playing the music of others to composing and playing his own music because it was more profitable. He spent considerable time on his music business as well, organizing a jazz festival in 2009 and recording several CDs. Because he was able to demonstrate his experience, expertise, and an effort to make a profit, Gullion won his case and was able to avoid having his losses recharacterized.
In Storey v. Commissioner, a documentary maker was able to successfully defend her business expenses for filmmaking. Lee Storey was a partner in a law firm and a full-time attorney who was heavily involved in the arts. When her children left home for college, Storey took an interest in filmmaking. She took a sabbatical from her legal work to attend a filmmaking academy and decided to create a documentary about Up With People. Returning to her legal practice, she worked nights and weekends conducting research and over 400 hours of interviews.
When the IRS challenged Storey’s losses, she was able to show that her filmmaking company maintained separate business accounts and a business credit card. She had obtained commercial general liability coverage and had engaged an accounting firm to manage tax matters for her. She also produced a written business plan and budgets for her documentary. When her initial efforts in seeking investors failed, she changed course and obtained a business line of credit. Although she’d incurred substantial losses developing the film, she had treated her business like a business and the courts ruled in her favor.
Why it Matters
In May 2015, the Treasury Inspector General for Tax Administration (TIGTA) released its audit report of the IRS’s methods for identifying taxpayers who improperly use hobby losses to offset other income, costing as much as $70.9 million in underpaid taxes. TIGTA suggested that the IRS have the information available to identify potential abuses of hobby loss deductions but have not been using that information. They recommended that the IRS make better use of its research capabilities and the IRS agreed to step up their enforcement of hobby loss rules.
If the IRS challenges your deductions, they could recharacterize your business expenses as hobby losses and recalculate your tax liability for the years in question. You’ll owe the increase in tax as well as interest on the balance and possibly accuracy-related penalties of up to 20 percent of the underpaid tax.
The IRS has a long reach for challenging losses. Generally, they can go back three years from the due date of the return or the date the return was filed, whichever is later, to challenge a return. However, the limitations can be extended if there is a substantial omission (more than 25%) of gross income on your return. In those cases, the IRS can go back six years from the date the return was due or filed.
Bottom line? If you plan to take on a side business, be sure you’re running it in a business-like manner. Demonstrating that effort can save you from a hefty tax bill and a big headache in the years to come.
Janet Berry-Johnson is a CPA and a freelance writer with a background in accounting and insurance. Her
writing has appeared in Forbes, Parachute by Mapquest, Capitalist Review, Guyvorce, BonBon Break and Kard Talk. Janet lives in Arizona with her husband and son and their rescue dog, Dexter. Outside of work and family time, she enjoys cooking, reading historical fiction, and binge-watching Real Housewives.