Is It a Hobby or a Business? It Matters to the IRS
Is it a hobby or a business – that’s a question you need to ask before you try to deduct certain expenses on your taxes. It may seem like a loophole. Do something you love to do, then deduct your costs come tax time. But the IRS has strict criteria you need to meet before you can consider doing it.
Basically, if it’s a business, you declare all your business income, and you deduct your costs and expenses. If your business has a net loss for the year, you may be able to use that loss to offset other sources of income (like a W-2 job).
But if it’s a hobby, you still need to declare any money you might make, but your costs and losses aren’t deductible.
Is It a Hobby or a Business? The Guidelines
The primary difference between a hobby and a business centers on your intent and expectation of profit. A hobby is pursued for pleasure without the goal, necessarily, of making money. On the other hand, you actively and continuously operate a business with a good-faith intention to generate a profit.
The IRS doesn’t rely on a single factor to determine if you are running a business or a side-hustle hobby. They look at the “totality of circumstances.” These include things such as business-like conduct. That is, do you keep careful and accurate books and records? Do you operate according to a formal business plan? The IRS also considers whether you put in the necessary time to indicate a real effort to make your operation profitable.
Importantly, the activity needs to actually make a profit some years. Generally, if an activity turns a profit in three out of five consecutive years, the IRS presumes it is a business (two out of seven years for horse breeding).
The IRS will also look at whether you rely on the income from this activity for your livelihood.
Is It a Hobby or a Business? Legal Requirements
Hobbies don’t require formal registration, licensing, or legal structures. You do not need a business bank account or a specific tax ID. However, businesses must follow local, state, and federal laws. This means you may need to register a business name, acquire an Employer Identification Number, obtain specific business licenses, and operate out of properly zoned areas. And the IRS likes to see a separate, dedicated bank account for the business.
Links
RBC Wealth Management offers this guide if you’re considering turning your hobby into a business.
Lastly, you can learn more about our services here!
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