It’s important to understand the difference between a business and a hobby because a legitimate business can deduct its expenses and possibly take a loss if it isn’t profitable. But if the IRS considers your activity as a hobby, you can’t deduct expenses to get a loss to offset other income. This article discusses the criteria used by the IRS for determining whether an activity is a business or a hobby.
How To Tell If You Have a Business or a Hobby
The IRS distinguishes between legitimate businesses and hobby activities for the purpose of taxes. The agency considers a business as a for-profit entity and a hobby activity as a not-for-profit activity. According to the IRS, a legitimate business has a primary purpose of “income or profit” and is engaged in a profit- or income-seeking activity “with continuity and regularity.”
IRS Nine Factors Test
The IRS has a list of nine factors to be used in determining whether an activity is a legitimate business or a hobby, considering each case on its own merits: Some types of income have greater potential to be hobbies, and the IRS looks at them more closely. These activities include fishing, craft sales, dog breeding, horse racing, photography, and writing.
Business vs. Hobby Rules for Business Types
Small businesses formed as sole proprietorships, partnerships, or limited liability companies (LLCs) are subject to these business-vs-hobby rules. S corporation profits and losses are part of their owner’s personal tax returns, so hobby loss rules apply to S corp owners. However, corporations are separate business entities, so hobby-loss rules don’t apply.
How To Deduct Expenses as a Business or Hobby
A business owner of a for-profit business can deduct ordinary and necessary business expenses in full. If the business has a loss, it can be taken to offset other income on the owner’s personal tax return. In the past, hobbyists could deduct expenses up to the amount of their hobby income, but no more. Beginning with the 2018 tax year, the Tax Cuts and Jobs Acteliminated the ability of hobbyists to deduct non-business expenses as miscellaneous expenses on Schedule A of Form 1040. The owner must still report the hobby income on their tax return.
Postponing IRS Determination on Your Business Case
You may want the IRS to postpone making a determination on whether your activity is for-profit or not-for-profit by making an election to give you a longer time to make a profit. Use Form 5213 for this purpose. You should make this election within three years after the due date of your return for your first tax year you engaged in this activity. So, if you started your business in January 2021, you should make this election before April 2025. The advantage of making this election is that the IRS will not immediately question whether your business is for-profit or not. It gives you three more years to show a profit. But, if you don’t have the required years of profit, the limit can be applied retroactively to any year with a loss in the five-year period.
How To Improve Your Position as a For-Profit Business
To be considered a legitimate business, it will help if you can show that you are following good business practices like:
Setting up a separate business checking account Keeping business and personal expenses separate Maintaining a good business record-keeping system Registering your business with a state as an LLC Complying with other state and federal tax laws, including collecting sales taxes and paying annual state business renewal fees or franchise taxes Having regular business hours or maintaining a business website
Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning! Other factors can be considered, like whether you operate in a business-like manner, do marketing and promotion to encourage sales, and whether you depend on the profits for your livelihood. Each situation is reviewed on a case-by-case basis. Before 2018, you could deduct these expenses on Schedule A of Form 1040 as miscellaneous deductions, but the 2017 Tax Cuts and Jobs Act removed this deduction.
If the activity has large expenses with little or no incomeIf losses are being used to offset other income on the tax returnIf the activity results in a large benefit to the taxpayerIf past years don’t show any profits
The auditor will look at the nine factors that separate business and hobby activity and consider them on a case-by-case basis.
