Have you ever considered turning a favorite hobby into a source of income? Whether you enjoy baking, jewelry making, woodworking, or another creative pursuit, what starts as a passion project can sometimes become a profitable venture. However, earning money from something you love doesn’t automatically make it a business in the eyes of the IRS. Understanding the distinction between a hobby and a business is important, as each comes with different tax rules and limitations on deductible expenses.
Determining if you have a hobby or business
To start with, is your passion a business or a hobby? The IRS says people start a business to make a profit, whereas a hobby can be engaged in as a sport or for recreation. Here are some factors to help you decide:
- Do you carry on the activity in a businesslike manner—for example, keeping track of your finances with complete and accurate records?
- Does the time and effort you put into the activity indicate that you intend to make it profitable?
- Do you depend on income from the activity?
- Are your losses due to circumstances beyond your control?
- Do you have the knowledge to carry on the activity as a successful business?
- Have you made a profit at this in the past?
- Can you expect to make a future profit from the appreciation of the assets used in the activity?
The answers you give should be based on facts and circumstances.
How profitability affects your tax deductions
If you’re legitimately in a business, you can deduct expenses for that business and possibly take a loss if your business isn’t profitable. If you’re not in business to make a profit, the IRS considers that your activity is not for profit and says you cannot deduct expenses to get a loss to offset other income. Many legitimate businesses start out with a loss in their first few years. However, the IRS expects that a legitimate business is set up with the intention to make a profit. For example, if an artist wants to claim expenses, they must show that they are following good business practices and intend on making a profit.
Steps to establish your activity as a business
A legitimate business, according to the IRS, has a primary purpose to make income or profit and is engaged in with continuity and regularity. In general, although there may be exceptions, the IRS will let you call what you have a business if you earn a profit during any three out of five consecutive years. These include:
- Setting up a separate business account.
- Keeping business and personal expenses separate.
- Maintaining a good business recordkeeping system.
- Registering the business with a state as an LLC or partnership.
- Complying with state and federal tax laws, including collecting sales taxes and paying annual state business renewal fees or franchise taxes.
- Having regular business hours or maintaining a business website.
Final thoughts
Are you unsure about what you have on your hands, or do you want to explore turning your hobby into a business? SEK’s Business Tax & Advisory professionals are here to help. Contact us to learn more.
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