Avoid having your status challenged by the IRS by learning whether your work is a hobby or business.
More and more people are starting side businesses or side hustles. Maybe you work in marketing and on the side you start taking on some copywriting projects to earn some extra cash. Or you start making funky earrings, and after interest from friends and family, you start selling more seriously at local craft fairs.
But have you really started a business? Or is this just a hobby that happens to earn some money? And does it matter?
We’ll cover what you need to know to determine if you’re running a small business or if you just have a hobby, and how to ensure you run your business like a business in the eyes of the IRS.
What’s the Difference Between a Hobby and a Business?
At first glance, a hobby that earns money may look no different than a business. But there are very specific differences between the two. In fact, the IRS treats expenses incurred by a business very differently than those incurred by a hobby.
According to the IRS, a business earns a profit whereas a hobby does not.
Any money that you earn needs to be reported on your taxes as taxable income. But when it comes to expenses, that’s where things diverge.
After the changes to the Tax Cuts and Jobs Act (TCJA) in 2018, you’re no longer allowed to deduct any expenses related to your hobby. Previously these hobby expenses could be deducted using a Schedule A if you itemized your deductions.
Alternatively, expenses that are ordinary and necessary for operating a business can be deducted from income. And not only that, a net loss can be used to offset other income, including your wages, interest, and dividend income. So if you’re a sole proprietor who files a Schedule C with your Form 1040 and you show a loss on your Schedule C, that loss can be used to offset other income earned.
Say you’re a painter and run a small painting business on the side of a full-time job. You have expenses as a part of running your operation, like supplies, studio space, and a website. This year you earned $10,000 from your business and your expenses were $4,000 ($1,500 of which was cost of goods sold).
If your business is truly a business and you’re a sole proprietor, you file your business income and expenses on a Schedule C. You’ll include the $10,000 income and the full $4,000 of expenses, leaving you with $6,000 of taxable income.
But if your business is a hobby, you’re restricted as to what hobby expenses you can deduct. You still need to report the $10,000 in hobby income, but you’re only allowed to deduct the $1,500 cost of goods sold, so you’ll pay taxes on $8,500. The additional hobby expenses of $2,500? You won’t get a deduction for those.
Hobby or Business? The 9 IRS Factors
According to the IRS, a business is engaged in making a profit. A hobby is something you do mainly for pleasure. But there are gray areas: What if you enjoy your work and it was built around a passion of yours, like painting?
The IRS will presume that your business is engaged in making a profit if it has been profitable the past three out of five years. But it’s not only profit that the IRS looks at. Here are nine factors determined by the IRS that need to be considered before determining whether you run a business.
- You operate in a businesslike manner, and keep complete and accurate books and records
- You put time and effort into making a business profit
- The income earned is used to support yourself
- Any losses incurred are normal (in the start-up phase), or are from circumstances out of your control
- You make changes to try to improve your business profit
- You’ve started similar profitable businesses in the past
- Your business is profitable in some years
- You expect to make a profit on the business in future years from the appreciation of your assets
How to Ensure You Have a Business
If you’re concerned about having the IRS challenge whether your business is truly a business, there are steps you can take to challenge-proof your business. The nine criteria outlined by the IRS focus on how profitable your business is and how you run your business operations.
Here are some steps you can take that revolve around working to improve your profit, and running your business in the most professional manner possible.
- Keep accurate books and records: Business owners should work to keep things organized when it comes to bookkeeping. Send out formal invoices, do monthly bank reconciliations, keep track of your profit, and log transactions accurately.
- Maintain a separate business bank account and credit cards: Boost your professional credibility by having a business bank account and keeping your business funds separate from your personal funds. This also helps to ensure that you’re keeping accurate books and records, which will come in handy come tax time.
- Obtain proper licenses: If you want to appear professional, getting proper licenses and certifications will help show that you’re trying to run your business in a professional manner, not like a hobby.
- Review business performance regularly: Are there improvements you can make when it comes to how you make a profit? That might mean investing in a new marketing program, or looking at your product costs and negotiating a better deal with your supplier. Document what you’re doing to improve your business operations and profitability.
- Continue to learn: There is a lot to learn when starting a business, so document any steps you’re taking to improve your skills or grow your business knowledge.
- Create a small business plan: Take the time to create and update your business plan. It doesn’t need to be lengthy, but focus on how your business will make a profit, how long it will take to become profitable, and what you will do to get there.
- Track your hours: To show that you’re seriously working on your business, track the time you spend working on it, especially if you’re working another full-time job during the day.
Be diligent with documenting these steps and make sure that you truly treat your business like a business. If the IRS challenges you and determines that your activity is actually a hobby, it could disallow your business expenses and recalculate your tax liability.
When Does My Hobby Become a Business?
What if you started as a hobby, but it’s now become something that you’d like to turn into a business? That’s where the criteria the IRS lays out come into play. Aside from having the intention to run a business, you’ll want to make sure you operate it professionally and in accordance with its criteria.
There are instances when taxpayers have been able to successfully defend their businesses when the IRS wanted to classify them as hobbies.
Challenges Won By Business Owners
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, Gullion 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 from 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 earn income.
He made changes to his business, including 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 earned a better profit. He spent considerable time on his music business as well, organizing a jazz festival in 2009 and recording several albums. 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.
Storey vs. Commissioner
A documentarian 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 a serious 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 business 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.
Hobby or Business: The Bottom Line
If you plan to take on a side business, be sure you’re running it in a businesslike manner. Demonstrating that effort can save you a hefty tax bill and a big headache in the years to come.
This post was updated in October 2020.