Millions of U.S citizens have hobbies such as photography, travel, sewing, crafting, hunting, floral design, and coin collecting. By the IRS definition, a hobby is an activity that is not pursued for profit. On the other hand, a business is an activity that is carried out with the intention and expectation of earning a profit. The IRS claims that deductions of hobby expenses account for a substantial portion of the overstated adjustments, deductions, exemptions and credits that add up to over $30 billion per year in unpaid taxes.
The IRS provides nine guidelines to help distinguish a hobby from a business. The factors are comprehensive and must be considered together when determining if an activity is a business or simply a hobby, with no single factor being determinative. IRS Tax Regulation 1.183-2(b) provides the following factors-
1. Manner in which the taxpayer carried on the activity.
2. Expertise of the taxpayer and his advisors.
3. Time and effort expended by the taxpayer in carrying on the activity.
4. Expectation that the assets used in the activity may appreciate in value.
5. Success of the taxpayer in carrying on other similar or dissimilar activities.
6. Taxpayer’s history of income or loss with respect to the activity.
7. Amount of occasional profits (if any) that are earned.
8. Financial status of the taxpayer.
9. Elements of personal pleasure or recreation.
It can be confusing to know the differences between businesses that are entered into for profit and those that are not. An activity is presumed to be for profit if it generates a profit in at least three of the last five tax years, including the current year. The differences are:
Businesses Entered Into for Profit – All profits are taxable, and generally losses are deductible against some types of other income. The income and expenses are commonly reported on a Schedule C, such as for sole proprietorships and sole member limited liability companies, and the profit or loss is carried over to page one of the taxpayer’s 1040.
Businesses Not Entered Into For Profit (Hobbies) – Hobbies are not entered into for profit, and the government does not permit a taxpayer to deduct associated hobby expenses, in excess of any hobby income, on their tax return. Any income generated from a hobby is reported directly on a 1040, and any expenses not exceeding the income are deductible as miscellaneous itemized deductions on their Schedule A, assuming the taxpayer is not claiming the standard deduction, in which case they would be reporting income but not deducting the specific associated expenses.
The tax considerations are different for each activity, so it’s imperative that taxpayers understand the distinctions, and determine whether an activity is done with the intention to make a profit or is just a hobby for enjoyment. Generally speaking, in almost all cases you must pay tax on income from almost all sources, including hobbies, but sometimes an activity that begins as a hobby evolves into a business. However, how you report deductions for the two activities differ significantly in their tax implications, so it’s important to treat the activity properly on your income tax return.
Call our office at 410-497-5947 to speak with one of our experienced business law attorneys who can assist you in determining the proper treatment of these activities.