Is it a Hobby or a Business - Tax Implications and Perks

Is it a Hobby or a Business - Tax Implications and Perks

Do you have a hobby that creates a bit of cash flow? In this post we explore the gray area between a hobby and business and the tax considerations both situations.

From baking to knitting to woodworking to selling homemade crafts on Etsy, there are many ways to turn your hobby into a steady stream of income. But, since you’re making money, the IRS is involved too. Many taxpayers may ask:

  • Q: “When does my simple hobby turn into an actual business? 
    A: It depends, read on.
     
  • Q: “Can I write off or deduct my hobby expenses?”
    A:  Again, it depends, but probably not unless you keep records and are able to itemize deductions.
     
  • Q: “When will I get taxed on my hobby income”?
    A: The IRS will consider it taxable income if it goes beyond an “occasional garage or yard sale”.
     

Hobby vs. Business: How to Decide

When making the distinction between a hobby and a business, the IRS provides a few questions to help tell the difference. Typically, a hobby is done with the sole purpose of recreation or pleasure. But there’s no single deciding factor that determines if your hobby is a business or just a fun activity. 

If you are keeping records, intend to make a profit, depend on the income from the hobby, then you are probably running a business in the eyes of the IRS.

On the flip side, if you are running a business, but you have lost money in three of the last five years, the IRS may re-classify your activity as a hobby. This prevents you from using the losses to offset other income.
 

Tax Considerations for Hobbyist

The bad news is, income is taxable per the IRS (from a hobby, business, or pretty much anything). In the cases of businesses the IRS taxes profit (which is income minus expenses).  For hobbyists the IRS taxes income. They do allow deductions for certain hobby expenses but there are limits and strings attached. Hobbyists can deduct expenses up to 2% of their adjusted gross income but they must also itemize deductions (which adds complexity and isn't worth it for a lot of people). 

The only income that doesn’t need to be reported is from garage sales (virtual or in your driveway), but generally you’d be taking a loss on those items anyway.
 

The Biggest Differences Between a Business and a Hobby for Tax Purposes

Businesses enjoy special tax treatment in terms of a wide range of things they can deduct.  Losses can be used to offset other income. With a hobby that is different. If you are running a hobby that generates a loss you cannot use that loss to offset other income.

With a business there is also the possibility of taking a home office deduction or contributing to a tax sheltered retirement account. The downside to operating a business vs a hobby for tax purposes is the hefty self employment tax.  Local taxes may also be levied on self employment income.

Here is a breakdown of the differences between a hobby and a business:

 

Hobby

Business

Structure

For fun, casual, personal activity

For profit, organized, records of income and expenses

Must Claim on Taxes

Yes - Form 1040

Yes - Schedule C

Ability to Write Off Expenses

Limited

Broad

Losses Offset Other Income

No

Yes

Home Office Deduction Possible

No

Yes

Must Pay Self Employment Tax on Profit

No

Yes

Access to Self Employed Retirement Plans

No

Yes

Did you make a profit in last 3 / 5 years?

If NO, IRS thinks it is a hobby

If YES, IRS thinks it is a business

 

Be Aware of Auto Reporting

If your hobby activity is generating a lot of revenue through PayPal or Amazon, the IRS is watching.

PayPal and Amazon will file a 1099-K if your gross sales on the platform go above $20,000 in a given tax year. It will be linked to your tax ID number, so the IRS will expect you to claim this amount as income on your taxes. However, Paypal and Amazon don’t help you when it comes to reporting deductions against that income. It is up to you to have documentation to prove the expenses were legitimate if you want to use them to offset the income come tax time.
 

The Bottom Line

If you feel as though your hobby is toeing the line of a business, it may be wise to claim it as one. Starting a business can be complex, so hiring a tax advisor to guide you with any tax implications of your business can help you avoid penalties and audits.

The post Is it a Hobby or a Business - Tax Implications and Perks is part of a series on personal finances and financial literacy published at Wealth Meta. This entry was posted in Personal Finance
Leave a comment

The Wealth Meta community is based on authentic and insightful discussions. The best comments are when people share their questions, goals, insights, and encouragement. Trolling is not tolerated!

Markdown syntax supported. Check out the Markdown help guide here.