Is my business a for-profit business or is it really more of a hobby? This is an important question to the IRS and an important determination you need to make.
Why is it important to make that determination? The way your income and expenses are treated on your tax return is vastly different if you are running an actual business as opposed to if you are enjoying making money at your hobby.
The IRS provides guidance on the determination of business or hobby in the form of what they call the nine “relevant factors.” When making the determination, no one factor is going to be the deciding factor. All factors will be taken into account as a whole to help us make that decision. Read below for more detailed information on those guidelines:
- Manner in which the taxpayer carries on the activity. A true business would be expected to carry on in a business-like manner. Accurate and complete bookkeeping, and separate bank accounts are just a couple of examples of that business-like manner.
- Expertise of the taxpayer or his or her advisors. The second indication of a for-profit business would be the skill or expertise the business owner has, or those who work for him/her, or the business advisors.
- Time and effort expensed by the taxpayer in carrying on the activity. The for-profit motive could be indicated by the amount of time the taxpayer devotes to the business as well as those whom the taxpayer employs.
- Expectation that assets used in the activity may appreciate in value. Though most tangible personal property depreciates, a business may own assets which will become more valuable in the future. Those assets would be land, and intangible assets such as name and goodwill.
- Success of the taxpayer in carrying on other similar or dissimilar activities. This factor points to other activities from the past. The fact that the taxpayer ran a profitable business in the past points to the success and possible viability of a new venture.
- The taxpayer’s history of income or losses with respect to the activity. If the activity has losses year after year, the IRS might question whether the business is being carried on for profit. It makes sense that a person would start a business with the intent to make money and when there are sustained losses, the owner would figure out that it makes sense to shut it down.
- The amount of occasional profits, if any, which are earned. Here the investment would be weighed against the profit earned to determine whether the business is engaged in for profit.
- The financial status of the taxpayer. The question here would be, “Is the taxpayer engaging in an activity for the purpose of lowering the taxable income because of substantial income from other sources?” The aspect of personal pleasure or a recreational element comes into the determination.
- Elements of personal pleasure or recreation. Though it is great to receive pleasure and fulfillment from your work, it can be an indicator of whether or not your activity has a for-profit motive. This last factor is not the top determining factor but it plays a part in the whole picture.
Here is a link to the IRS website that reflects the above guidelines.
What is the tax difference between a business and a hobby?
In simple terms, a sole-proprietor business (or a qualified joint venture for married taxpayers) is reported on the Schedule C, Profit or Loss from Business. This is where the gross receipts and the allowable expenses are claimed, resulting in the gross profit. (Now, this reporting can be as simple as stated, or it can be very complex. For the purposes of this article, we are keeping it simple.) A net profit from a business is generally subject to self-employment tax, as well as regular income tax. The net result could be a loss, and that loss may reduce the AGI and taxable income of the taxpayer.
On the other hand, hobby income is claimed on the Schedule 1, and the only deductions allowed from hobby income are the costs of goods sold (such as materials and labor). Other expenses are not currently deductible. (Between the years 2018 and 2025, hobby expense deductions are not allowed as they are part of the suspended miscellaneous itemized deductions subject to the 2% of AGI limitation on the Schedule A.) The profit from a hobby is not subject to self-employment tax. The loss from a hobby cannot be used to offset other income.
As always, this article is meant for informational purposes only and does not constitute tax advice. Every situation is unique. This article is meant to guide you into asking informed questions about your own tax situation. Our current clients should contact us at 912-335-5404 with specific questions pertaining to their situation. As well, we welcome newcomers to call us and set up an appointment with our qualified EA professionals to discuss their unique situation.