When it comes to taxes, the distinction between a hobby and a business can have significant implications. While expenses related to a business are tax-deductible, hobby expenses are not. This distinction has led the IRS to closely monitor the line between the two.
If you engage in a hobby and spend $500 on expenses, you cannot claim those costs as deductions on your tax return. However, if you are running a business, even a small one, you can deduct your expenses, effectively reducing your tax liability..
For instance, let’s say you operate a “business” breeding, training, and caring for animals and incur a $10,000 loss each year. By reporting this loss on Schedule C of your Form 1040 and writing it off against your salary, you can reduce your actual costs to $6,000, assuming a combined state and federal tax rate of 40%.
If your animals are considered a hobby, you cannot claim a loss. However, before attempting to convert your non-deductible hobby into a deductible business, it’s crucial to exercise caution. The IRS closely scrutinizes this area, and the key difference between a hobby and a business lies in the intention to make a profit. Businesses operate with the primary goal of generating a profit, while hobbies are pursued for pleasure or recreation.
The IRS generally presumes that an activity is operated as a business if it generates a profit in at least three out of five years. However, even if you have a profit in only one year out of ten, you can still try to convince the IRS that you are running a business.
Nonetheless, this may require going through a challenging process, potentially involving legal proceedings. Maintaining good records and conducting your activities in a business-like manner is crucial in supporting your case.
It’s important to note that regardless of whether an activity is considered a hobby or a business if you receive more than $600 for goods and services through online marketplaces or payment apps, you may receive a Form 1099-K. Profits from such transactions, including the sale of personal items and services, are taxable income that must be reported on your tax returns.
When determining whether your project qualifies as a hobby or a business, no single factor is determinative. It’s recommended to review all relevant factors to make an informed decision. Here are some questions that can help you evaluate whether you have a hobby or a business:
- Do you conduct the activity in a business-like manner, maintaining complete and accurate books and records?
- Does the time and effort you invest in the activity demonstrate an intention to make a profit?
- Has the activity generated a profit in some years, and if so, how much?
- Can you expect to make future profits through the appreciation of the assets used in the activity?
- Do you depend on income from the activity for your livelihood?
- Are any losses due to circumstances beyond your control or normal for the startup phase of your business?
- Do you make changes to your operations to improve profitability?
- Do you and your advisors possess the necessary knowledge to carry out the activity successfully as a business?
To navigate this distinction effectively:
- Aim for income to exceed expenses. Demonstrating that your income from the activity exceeds your expenses makes it less likely that the IRS will question your business status.
- Maintain good records. Conducting yourself in a business-like manner, supported by accurate and comprehensive records, can strengthen your case.
- Show a profit in three years out of five. If you can achieve profitability for at least three years out of every five (or two years out of seven for horse breeding), the IRS will presume that you are operating your activity with a profit motive. This presumption is valuable as it reduces the need for contentious fact-based assessments.
- Plan your income and expenses. As our tax system operates on an annual basis, you have some control over when you receive income and incur expenses. Managing this timing can help you meet the requirement of showing a profit three years out of five.
- Consider deferring the determination of the profits. You can elect to postpone the determination of your profit motive until the fourth year of your business (or the sixth year for horse-related activities) by filing Form 5213. This election provides additional time to ramp up and achieve profitability. However, exercise caution as this election may draw attention to the profit-motive issue and extend the IRS statute of limitations for examination.
Whether you have a hobby or a business, maintaining good records is essential when filing your taxes. If you have any questions about if your activity is a business or hobby, speak to your tax advisor. And if you need bookkeeping assistance, we are here to help. You can reach us at 310-534-5577 or [email protected].
