It Might be a Business after all
If you have income from sources other than your main job, how do you know whether it’s income from a business or hobby? Like many of us, you’ve probably dreamed of turning a hobby or pastime into a regular business. Or perhaps the current economic condition necessitated that you turn to a side job to earn extra money. You won’t have any unusual tax headaches if your new business is profitable. However, if you consistently generate losses, the IRS may step in and say it’s a hobby—an activity not engaged in for profit—rather than a business. The distinction between the two makes a big difference in your taxes. Look at the following nine factors when making the determination.
- Operate in a businesslike manner? Do you keep accurate books and records? If so, you are more likely to have a business than a hobby.
- Have expertise in the area or hire experts? If you have expertise or hire an expert, this is evidence of a business, rather than a hobby.
- Devote a significant amount of time and energy to the activity? The more time you spend on the activity, the more likely it’s a business.
- Expect that assets increase in value? If so, then it is likely a business.
- Have other, similar businesses? If you have several similar activities that you treat as businesses, this activity will likely be treated that way too.
- Have a history of profits? Too many years of losses increases the likelihood that an activity is a hobby.
- Have large profits? If you make large profits, it is more likely a business.
- Have other substantial income or capital from other sources? If so, that is an argument for hobby treatment.
- Get personal pleasure or recreation from the activity? If you participate in the activity for fun, hobby treatment is more likely.
Your hobby income is taxable, but hobby expenses are limited; you can only deduct the cost of goods sold (the cost that you incur in acquiring or manufacturing your product). For example, if your hobby is making jewelry, the cost of goods sold would include the beads and other products that you purchase to make the jewelry, but not the equipment you use to make the jewelry.
Under the hobby loss rules, you can claim certain deductions, such as state and local property taxes. Your deductions for business-type expenses such as rent or advertising from the activity are limited to your gross income, however. Furthermore, deductible hobby expenses must be taken on Schedule A of Form 1040 as miscellaneous itemized deductions subject to 2% of your adjusted gross income. Since miscellaneous itemized deductions are repealed from 2018 through 2025, deductible hobby expenses are effectively wiped out until 2026. This creates taxable income without offsetting deductions. There are two ways to avoid the hobby loss rules. The first way is to show a profit in at least three out of five consecutive years. The second way is to run the activity in such a way as to show that you intend to make it profitable, rather than operate it as a mere hobby. IRS regulations say the hobby loss rules won’t apply if the facts and circumstances show you have a profit-making objective.
How can you prove that you have a profit-making objective? In general, you can do so by running the new venture in a businesslike manner. More specifically, the IRS and the courts will look to the following factors: how you run the activity; your expertise in the area; the time and effort you expend in the enterprise; whether there’s an expectation the assets used in the activity will rise in value; your success in carrying on other similar or dissimilar activities; your history of income or loss in the activity; the amount of occasional profits (if any) that are earned; your financial status; and whether the activity involves elements of personal pleasure or recreation.
You aren’t on your own figuring this out. Come see us to walk through these factors, and we’ll help you make the right determination for your tax situation.