Operating a business on the side can give you valuable tax deductions as well as extra income. However, the Internal Revenue Service (IRS) decides if the business is actually a hobby or not. If the IRS says it is, you could lose the ability to deduct expenses from your income. The primary rule for determining whether an activity is a business or a hobby is if it produced a profit in at least three out of five years. Other considerations could come into play. However, that’s not definitive. We’ll discuss how turning your hobby into a business can affect your taxes and what the IRS looks for.
Talk to a financial advisor for help managing your tax liability.
How Turning a Hobby into a Business Affects Your Taxes
If you can find an activity you enjoy that also produces a profit, you can have fun while making money. And as an added benefit, you can get deductions to reduce your taxable income. Examples of businesses that potentially are enjoyable as hobbies could include musical performances, creating craft items for sale and guiding wilderness backpacking trips. If you charge money for playing music, selling your crafts or providing guide services, the income could make a business out of what would otherwise be a hobby.
At tax time, hobbies and businesses get treated very differently. The money you pay to engage in a business, such as purchasing a sound system for musical shows or mileage to travel to craft fairs, can be subtracted from sales revenues to reduce taxable income. If the business produces a loss, you can even deduct that loss from other income. That includes salary from working at a job, reducing your overall tax bill.
Making a business out of a hobby isn’t necessarily all good times, however. For one thing, if the IRS suspects you of trying to claim business losses from something that is really a hobby, you could be audited. An IRS audit isn’t likely, but it’s not fun either.
It’s more likely you could simply lose the ability to deduct losses if your business is ruled to be a hobby. This could increase your tax bill and remove one of the nice benefits of having a business that is as enjoyable as a hobby.
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IRS Guidelines for Identifying Businesses
The IRS uses guidelines to determine whether an activity is a business or a hobby. But these aren’t cast in stone. An activity doesn’t have to meet all of the guidelines to be ruled a business. And, even if it does appear to fit the business guidelines, it could still be categorized as a hobby. Here are the guidelines and some details about their application:
Safe harbor. The surest way to ensure your activity is seen as a business is to report a profit from it. You don’t have to make a profit every year, however. If your activity shows black ink at least three out of five years, it’s presumed to be a business. Again, this isn’t ironclad, but in most cases, it will suffice. Even if you aren’t profitable that often, your activity may still pass as a business if it meets one or more of the following guidelines:
Profit motive. A hobby is intended for enjoyment and recreation while a business is intended to make money. You may be able to convince the IRS you’re doing something for a profit even if you aren’t actually making money if you:
Have made money in the past from similar activities.
Are acquiring assets, such as land, that have the potential for price appreciation.
Are managing the activity in the same way as similar businesses.
Advertise or market to get customers.
Exert yourself to acquire suppliers and vendors.
Work at the activity full-time or at least expend significant effort.
Hire qualified employees to assist you.
Keep books and records to assist you in running the business.
Depend on income from the activity to pay living expenses.
Report normal losses that aren’t dissimilar from similar businesses or are due to uncontrollable circumstances such as fires, natural disasters or economic downturns.
IRS Guidelines for Identifying Hobbies
If your activity has certain other characteristics, it increases the chances the IRS will consider it a hobby. That’s even if it otherwise might be seen as a business. Here are some of those considerations:
Recreational aspects. If your activity is something usually considered fun, such as visiting beach resorts or trying out new restaurants, it will be more likely to be labeled a hobby than if it is something distinctly not fun such as, say, preparing tax returns or pumping out septic tanks.
Personal motives. If the IRS believes you’re doing the activity because you like it or find it relaxing, it will more probably be viewed as a hobby.
Other sources of income. If other activities, such as working or investing, are providing you with sufficient income to pay your bills, it’s less likely the IRS will see your activity as a business.
Reporting Hobby and Business Income
You’ll usually report income from a business, whether operated as a sideline or your main source of income, on Schedule C of your Form 1040. Schedule C has spots for you to record a wide variety of expenses. So you can accurately report the income from your business.
Income from a hobby that you don’t expect to run profitably also has to be reported. But it’s much less involved. You’ll do this on line 8j of Schedule 1 of your regular 1040.
Bottom Line
Hobbies turning into a business is a dream a lot of people have. Being able to enjoy what you do and make money off it is dream many want to have. It’s even better when it can be deducted to reduce your taxable income. But you need to make sure that your hobby is in fact a business. If the IRS finds out you’re using your hobby as a business when it isn’t, you could be audited. And to prove it’s a business, you need to be making a profit in 3 out of the last five consecutive years.
Tips for Filing Your Taxes
A financial advisor can help you during tax season. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you don’t know whether you’re better off with the standard deduction versus itemized, you might want to read up on it and do some math. Educating yourself before the tax return deadline could help you save a significant amount of money.
SmartAsset has free resources available to help you during tax season. Check out our income tax calculator today and get started!
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Source: https://finance.yahoo.com/news/irs-hobby-vs-business-means-140012229.html