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Hobby or Business? The IRS Wants to Know

Keep careful records so you don’t get a nasty surprise at tax time

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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.

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“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.

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IRS gives guidelines for determining a gig’s status

The IRS lists nine things to consider when assessing if an activity is a hobby or a business: 

  • Whether the activity is carried out in a businesslike manner and the taxpayer maintains complete and accurate books and records
  • Whether the time and effort the taxpayer put into the activity demonstrate that they intend to make it profitable
  • Whether they depend on income from the activity for their livelihood
  • Whether any losses are due to circumstances beyond the taxpayer’s control or are normal for the start-up phase of their type of business
  • Whether they change methods of operation to improve profitability
  • Whether the taxpayer and their advisers have the knowledge needed to carry out the activity as a successful business
  • Whether the taxpayer was successful in making a profit from similar activities in the past
  • Whether the activity makes a profit in some years, and how much profit it makes
  • Whether the taxpayer can expect to make a future profit from the appreciation of the assets used in the activity

CPAs say that the tax agency’s nine items are not hard-set rules of which you must meet a certain number. “Even though the IRS has these guidelines that they use to determine if an operation is a hobby or business, it all depends on the facts and circumstances, meaning how that person is running that business,” Downey explains. 

Ford agrees, noting that the IRS is evaluating each case to determine whether the taxpayer is treating the venture as a true business. “It can’t just be sort of flying by the seat of your pants,” Ford says.

Provide evidence of a business

Evidence of a true business can include using a separate bank account for the income and expenses of the gig. You want to show an intent to generate profit by creating a business plan, advertising, printing business cards and taking classes to deepen your knowledge of the activity.

Another factor is whether the taxpayer needs the income as a means of support. If they do, that can be evidence that the activity is a business. “If you are living off of the income from that business and you have losses because you’re paying all these expenses, then it’s a really, really strong position that it is a business and this is how I make my livelihood,” Downey says.

If the gig income is used for travel or other supplemental spending, that doesn’t mean it can’t be a business, according to Ford. “You want to show the IRS that it’s your intent to be profitable in that business. It’s all very subjective.” 

Keep good records

For a hobby, tracking income and expenses may be as simple as recording entries in a notebook. “Even if you take the front part of the book and write down all the income, every sale that you made, and then in the back section of the book start writing out every expense that you have — in keeping all of those receipts together in a notebook, that will be the bare minimum,” Downey says. As the venture grows, you will likely want to use a spreadsheet or software to track costs and income. “It’s just a matter of what that person is comfortable with.”

But the bottom line is to maintain accurate and clear records, especially if you want to prove your intent is to make a profit as a business. “The best way to show the IRS your intent is to have documentation,” Ford says. “It’s putting support or some documentation around what your written intention is for the business.”

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Burden of proof can shift to the IRS

If a taxpayer meets the safe harbor test, which is turning a profit in three of the past five consecutive years (or two of the past seven years for horse breeding and racing), then it’s up to the IRS to demonstrate you are not operating a business.

“The burden of proof is now put on the IRS. So they would have to put resources into disproving that you’re a business,” Ford explains. “The IRS could come in and argue that it’s not, but they’d have to have the support to do it. … You’d have to be making a lot of money versus your expenses to make it worthwhile to them.”

If you have not made a profit in five years, you may need to provide proof to the IRS that your gig is a business. You can argue that you are operating a business by showing that you have a license, a business bank account and past experience in the venture and that this type of business can take a few years to make a profit, Downey suggests. “Those types of things show that this is being operated as a business.”

Maintaining documentation is crucial. “If you are running a legitimate business, don’t be afraid if you’re not making a profit, and don’t think someone’s going to hammer down on you. The number one key is keeping track of all of your income and all of your expenses to make that determination on whether it’s a hobby or not,” Downey says.

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