In today’s world of side hustles, turning your passion into your job, and marketplaces that allow anyone to make money off anything, the line between a hobby and a business can seem like a fuzzy one. But since hobbies and businesses are treated differently tax-wise, it’s important to understand where your work falls.
The Tax Differences Between Hobbies and Businesses
While you have to report income made on both hobbies and businesses to the IRS and pay taxes on it, there’s a pretty big difference when it comes to deductions.
Businesses can deduct any and all ordinary and necessary expenses related to running their business, even if those expenses exceed income. In other words, businesses are allowed to take a loss, and even deduct those operating losses from other income (e.g., deduct the loss on your side gig from the income from your full-time job), or deduct losses from previous or future years to reduce taxable income.
With a hobby, you still have to report the income, but you can’t make any deductions with the recently-passed Tax Cuts and Jobs Act—meaning you’ll be paying taxes on every cent you make, even if you’ve put a ton of money into making it.
Hobbies vs. Businesses (According to the IRS)
Okay, filing as a business seems like a much better deal, so you’ll just tell the IRS you have a business if you’re making any income—right? It’s not that simple. The IRS has guidelines that distinguish businesses from hobbies.
Mostly, it comes down to whether you’re making a profit or have the intent to make a profit. If you’ve been steadily making a profit from your work, that makes it easy. But not all businesses make money immediately—sometimes losses are necessary to build your business in the long term. That’s where it comes down to the intent and ability to ultimately make a profit, and the questions below are what the IRS looks at to distinguish businesses from hobbies:
- Do you carry on the activity in a businesslike manner and maintain complete and accurate books and records?
- Do you put in time and effort to try and make this project profitable?
- Do you depend on the income from this activity for your livelihood?
- Are your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business)?
- Do you change your methods of operation in an attempt to improve profitability?
- Do you or your advisors have the knowledge needed to carry on the activity as a successful business?
- Have you been successful in making a profit in similar activities in the past?
- Has the activity makes a profit in some years?
- Do you expect to make a future profit from the appreciation of the assets used in the activity?
In short, do you primarily do the work because you enjoy it (and any money made is just a happy bonus), or are you hustling to make sure this work can truly sustain you? Determining this is a bit of a gray area. No one of these questions determine definitively whether you’re a hobby or business, but if the answer to a good number of them is ‘yes,’ it’s more likely you can convince the IRS you’re running a business (even if you aren’t profitable yet).
What if My Business Gets Categorized as a Hobby?
If you’ve had a loss for 3 of the past 5 years, you’re at risk of the IRS categorizing you as a hobby rather than a business. If they audit you to determine if you really are a business or not, there are a few things that could help you make your case.
One is having accurate books and records for your business—this has to do with the “conducting the activity in a business-like manner.” Make sure you’ve maintained a good financial record-keeping system and have all documents—like invoices, receipts, and mileage records—easily on hand.
Having a written business plan that explains how you’re working to make adjustments so you start making a profit can also help show that you’re taking this business seriously.
Finally, taking steps to make your business more “official” can be helpful if this occurs: registering as an LLC or partnership, setting up a business checking account and keeping these expenses separate from personal expenses, having a website, etc.
Abridged by Amy
- According to the IRS, the difference between businesses and hobbies is the intent and ability to make a profit off your work.
- Businesses and hobbies are handled differently tax-wise; you can use deductions to reduce your taxable income on a business and you can take a loss, while you can’t do either with a hobby.
- If you’ve taken a loss for 3 of the past 5 years, the IRS may audit you to determine if you’re really running a business. There are steps you can take to help prove you’re the real deal.