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Let’s say you’ve taken up beekeeping over the pandemic, and now you’re actually starting to sell honey. At what point can you call your hobby a business? It may not matter to you, but it matters to the IRS, and you don’t want to get stung at tax time.
The Internal Revenue Service (IRS) differentiates between a business, which operates to make a profit, and a hobby, which is for sport or recreation.
We talked with experts about what you need to know (and why you need to know it) about the difference between a hobby and a business and how the distinction could affect your 2022 tax return, which you’ll file next year.
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Income must be reported
First, any income received is taxable, whether it’s from a business or a hobby. Losses from a hobby are not deductible, but business losses typically are.
Where you report income on your tax return depends on how the gig is classified. Business income and expenses are reported on Schedule C, “Profit or Loss from Business (Sole Proprietorship),” and a filer must pay self-employment tax of 15.3 percent on net earnings for Social Security and Medicare taxes. Hobby income is reported on Schedule 1, “Additional Income and Adjustments to Income,” on a line labeled “Activity not engaged in for profit income.”
Making quarterly estimated tax payments is important once you are earning sufficient income. “For anyone starting out in business, it’s really important to get started making these payments. Many people don’t and end up getting an unpleasant surprise at the end of the year,” says IRS spokesperson Eric Smith.
If your pursuit is a side gig and you have a regular W-2 job as well, or regularly receive pension payments, another option is to increase your withholding to cover any possible shortfall from the gig’s income, Smith advises. The IRS’ Tax Withholding Estimator can help you calculate how much money you need to have taken out.
A business offers more deductions than a hobby
A hobbyist can subtract the cost of goods sold when determining the income to report on a tax return, but not more than the income. In the beekeeper example, the jars for the honey would be a deductible cost — but that’s it. In the past taxpayers could claim hobby expenses as miscellaneous itemized deductions if they itemized on Schedule A, but that option was suspended starting with the 2018 tax year by the Tax Cuts and Jobs Act of 2017.
“If you’re incurring significant expenses [on a hobby], then you’re really losing any tax benefit from that,” says Mary K. Ford, CPA, tax director at SobelCo. “You have to report the profit, but you’re getting whipsawed because your income could get substantial and your expenses are substantial, but you can’t offset the two. The pitfall is that you’re going to be paying income tax on an activity that isn’t necessarily profitable, and that’s costly to you.”
A business offers more opportunities for deductions, such as writing off overhead costs or the part of your home where the work is done. Going back to the honey operation, the owner can deduct the fee to sell at a farmers market and the mileage to reach the market, as just two examples. “You want to take advantage of those deductions that are there for you,” says Catina Downey, a CPA who specializes in small-business accounting in Richmond, Virginia.
A business can also apply for a sales-tax exemption, allowing the owner to delay paying the tax until the goods are sold and the customer pays the tax. A hobbyist is not eligible for the exemption and must pay sales tax upfront on all supplies needed for the operation.