Over the years, I have regularly helped my clients with their tax audits after the IRS determined that their businesses were really hobbies. Filing taxes as a sole proprietor of a business means you can take advantage of tax deductions you may not have access to if your activity is a hobby, so it’s important to know the difference.
Distinguishing between a hobby and a business for tax purposes
One of the main factors the IRS uses to distinguish between a hobby and a business is the concept of a profit motive. In order for your activity to be considered a business, you must have the intention of turning a profit—either very soon or over time due to the long-term appreciation of your product or idea.
- The IRS asks other questions when determining whether an activity is a hobby or a business, including:
- Is the taxpayer dependent on the income from the activity?
- Are losses due to circumstances beyond the taxpayer’s control, or did they occur upon the start-up of the business?
- Has the taxpayer tweaked his or her operations to increase profits?
- Does the taxpayer have the knowledge needed to make the activity a successful business, either alone or with the help of advisors?
- Has the taxpayer previously made profits from similar activities?
- Are there some years in which the activity makes a profit?
You can have a business without making an immediate profit
A woman designing and patenting space satellites would not turn a profit in the short term. Her legal and development costs would be high, and it could take a decade or more for her business to become profitable. But, in the end, even one sale could generate a profit of millions of dollars, which is likely the developer’s intent and the reason she is working on the project.
In this example, because there’s an intention to turn a profit after many years, this woman’s hobby would almost certainly be considered a business. Assuming this is the case, she could claim tax deductions for the activities related to her project.
Getting paid doesn’t guarantee your hobby is a business
Based on IRS criteria, certain activities may be considered hobbies even if the hobbyist gets paid. While he or she would still be required to report the income to the IRS, that person would be unable to take advantage of the same tax deductions from which a business owner can benefit.
Take, for example, my old friend Jack, a retired naval sergeant who made beautiful trophy cases. He polished the wood by hand and customized the compartments to fit the recipient’s items of pride. When he made a case for the family of a deceased soldier, he would take special care to create compartments for the flag that had covered the casket as well as any medals of honor, special pictures, and other personal items.
Jack’s trophy cases were highly sought after by veterans from all the armed services, and he made each one with love. He earned a bit of money from each one, but year after year he took took a loss of $5,000 or more on what he was calling a business.
Because Jack went years without making a profit and would not make a profit in the future from appreciation of his wares, he had to change his reporting from calling his work a business to calling it a hobby.
How do you report the financial aspects of a hobby properly?
Hobby-related expenses may only be deducted when you itemize. Report the income generated from your hobby as “other income” on line 21 of Form 1040, and itemize the deductions on Schedule A as “miscellaneous itemized deductions.”
The expenses have two limitations. You can only deduct the expenses from income that is generated from the hobby, and these expenses are reduced by 2 percent of your adjusted gross income (the amount in line 37 on Form 1040).
This means if you make $50,000 per year, you would not be able to deduct your first $1,000 of expenses.
If you don’t itemize, you may find yourself reporting the income and getting no benefit from the expenses. But when you’re doing something you love, who cares if you get tax benefits?
Eva Rosenberg, EA is the publisher of TaxMama.com, where your tax questions are answered. She is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com and tax courses you might enjoy at http://www.cpelink.com/teamtaxmama.