Hobby or Business? How the IRS Tells the Difference

An activity that generates income does not automatically qualify as a business in the eyes of the Internal Revenue Service. The IRS uses a set of criteria to differentiate between a personal hobby and a for-profit business. This distinction has important consequences for how you report income and whether you can deduct expenses, making it important for anyone with a side income to understand.

The IRS Nine Factor Test

The IRS uses a nine-factor test to determine if an activity is a business or a hobby, focusing on the taxpayer’s intent to make a profit. The analysis considers all facts and circumstances, and no single factor is decisive.

A primary consideration is the manner in which you carry on the activity. Operating in a businesslike fashion, which includes maintaining complete and accurate books, having a separate bank account, and obtaining any necessary licenses, suggests a profit motive. For instance, a baker who tracks every sale and expense in accounting software presents a case for a business, unlike someone who occasionally sells cakes and co-mingles the income with personal funds.

Devoting significant time and effort to an activity indicates an intention to make it profitable, especially if it is not for personal enjoyment. For example, spending weekends developing a software application shows more commitment than casually playing a guitar for relaxation, even if both activities generate income.

The IRS analyzes your dependency on the income for your livelihood. If you have other significant income sources and the activity’s losses provide tax benefits, it may be seen as a hobby. Conversely, if the income is a necessary component of your budget, it points toward a business.

Personal pleasure is weighed against the profit motive. If personal satisfaction is the primary driver, the activity may be a hobby. For example, a person who travels to photograph rare birds and sells a few prints is likely pursuing a hobby, unlike a photographer who markets their services for weddings.

A history of losses over several years might indicate a lack of a profit motive. However, the IRS acknowledges that many new businesses are not profitable during their startup phase. If losses continue beyond a normal startup period, the IRS will look for changes in operation intended to improve profitability.

The amount of occasional profit that is earned is also relevant. Making a substantial profit in some years can be strong evidence of a profit motive, even if other years show a loss. The analysis considers the size of the profit in relation to the losses and the amount of the taxpayer’s investment.

Your expertise, or your reliance on expert advice, can support a business classification. Taking steps to become knowledgeable about the industry’s business practices shows a professional approach. This can include formal education, research, or hiring consultants.

Your success in carrying on other similar or dissimilar activities is an indicator. If you have a track record of turning past ventures into profitable enterprises, it suggests you have the intent and ability to do so again.

An expectation that assets used in the activity may appreciate in value is also considered. Even if an activity is not currently generating a profit from its operations, a reasonable expectation that its assets, like land or equipment, will increase in value can point to a profit motive.

Tax Implications of a Hobby

If an activity is classified as a hobby, you must report all income it generates to the IRS. This income is considered “Other Income” and is reported on Schedule 1 of Form 1040. The law requires all income from any source to be included, regardless of how small the amount is.

The most significant tax consequence for a hobby is that expenses are not deductible. Under current tax law, you cannot use the costs of materials, supplies, or any other outlay to offset the income earned from the hobby. For example, if a person earns $1,000 from selling handmade jewelry but spent $1,200 on supplies, they must report the full $1,000 of income and cannot deduct the $1,200 in expenses.

Tax Implications of a Business

When an activity qualifies as a business, its financial activities are reported on Schedule C, Profit or Loss from Business, filed with your Form 1040. On this form, a business owner reports all gross income and can deduct all “ordinary and necessary” expenses. An ordinary expense is one that is common and accepted in that particular type of business, while a necessary expense is one that is helpful and appropriate for the business.

Common deductible expenses include the cost of goods sold, advertising, office supplies, and business-related travel. These deductions reduce the business’s gross income, and you are only taxed on the net profit.

A business’s net profit is also subject to self-employment tax, which covers Social Security and Medicare. The rate is 15.3%, consisting of 12.4% for Social Security up to an annual income limit and 2.9% for Medicare with no limit. This is in addition to any regular income tax owed.

You can deduct one-half of the self-employment tax you pay. This deduction helps create some parity with the traditional employment structure, where an employer pays half of an employee’s Social Security and Medicare taxes.