Is your activity a hobby or business? Do you want to write off expenses from your hobby? Do you want to turn your hobby into a business? Tax-wise, it can be beneficial to turn your hobby into a business because you can write off losses and expenses. The IRS has a checklist for determining the distinction between the two. It might help you to take the next steps to define your activity for yourself.
The IRS Definition of a Hobby
Tax deductions for hobbies are limited in two ways. They are limited to the amount of profit from the activity and because hobby expenses are reported as miscellaneous itemized deductions. This means that the total deductions can’t exceed 2% of the gross income. If you don’t itemize on your tax return and take the standard deduction, you don’t get the deductions at all! Not really fair, right?
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The IRS Definition of a Business
If considered a business, all business deductions would be allowed, without limitation. Any business losses would also be allowed to offset income from other sources, including wages. So why not turn your hobby into a business?
To be a business, you must operate with the intent to return a profit. If you are able to show a net profit in 3 out of the last 5 years of the business (it’s 2 of 7 years for breeding, training, showing, or racing horses), the IRS will agree that you are operating your business for profit and will not question the classification. There are other, more objective, ways the IRS uses to make the determination if you don’t meet the profit expectations.
IRS Business vs. Hobby Checklist
The IRS has a specific checklist of items it uses when trying to decide whether an activity is a hobby or business. See how many apply to yours. In order to be considered a business, it should meet most of the criteria. You can view the checklist on the IRS website here: Is Your Hobby A For-Profit Endeavor
1. You carry on the activity in a business-like manner
2. The time and effort you put into the activity indicate you intend to make profitable
3. You depend on the income for your livelihood
4. Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business)
5. You change your methods of operation in an attempt to improve profitability
6. You (or your advisors) have the knowledge needed to carry on the activity as a successful business
7. You were successful in making a profit in similar activities in the past
8. The activity makes a profit in some years
9. You can expect to make a future profit from the appreciation of the assets used in the activity
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How to prove your activity is a hobby or business
1. Make business cards
2. Open a separate bank account
3. Obtain any necessary licenses or permits
4. Engage in advertising or marketing (Websites can offer tax benefits)
5. File a fictitious name.
It’s important to understand these steps and be proactive to qualify your activity as a business so that you will be ready if the IRS comes knocking on your door.
By Frank Hambalek, CPA
Partner at WHH
Frank specializes in high-level consulting and financial reporting work with medium- to large-sized construction and real estate companies. With his talent in managing systems and people, he has served as an outsourced CFO for many clients. Other specialties include internal fraud prevention, GAAP standards, and the new leasing standards.
