Is Your Hobby Really a Business?
It doesn’t matter if you knit hats or create miniature figurines—once you start making money, you need to figure out if your hobby is really a business. Why? Because the decision has significant implications for your tax bill.
Let’s dive in.
Hobby vs. Business
If you make money with a hobby or business, the IRS wants to know about it. You’ll need to declare your gains on your tax return. However, what happens next depends on how you designate your activity.
Hobby Income
If you do something solely for personal enjoyment and don’t care about making money, then it’s considered a hobby. As we mentioned, you’ll have to report any income from this hobby, but you won’t have to worry about self-employment taxes. However, you also won’t be able to deduct any hobby-related expenses.
Let’s say you spend $1,000 on art supplies for the year and make $500 selling paintings. You can’t claim this loss on your tax return and must absorb the entire cost.
Business Income
Businesses operate to make money. If that’s your goal, you have a business, not a hobby. The IRS uses multiple factors to make the determination. They include:
- Profit motive: Are you trying to make money?
- Effort: Do you dedicate significant time and effort to the activity?
- Expectation: Do you expect your business to grow over time?
Unlike hobby expenses, business expenses are deductible. You can deduct supplies, equipment, travel costs, and more. These deductions can significantly lower your tax bill. If your business has a losing year, you can even use the loss to reduce your taxable income from other sources.
How to Make the Switch
If you realize your hobby is actually a business, there are a few steps to take.
- Get an EIN: An Employer Identification Number (EIN) is like a Social Security number for your business. You’ll need it to file taxes unless you operate as a sole proprietorship or single-member LLC.
- Register Your Business: Depending on where you live, you may need to register your business with the state government. This usually involves filing paperwork and paying a fee.
- Open a Separate Bank Account: Keep your personal finances separate and open a business bank account.
- Keep Records: Track all income and expenses throughout the year.
How Do You Report Business Income?
If you have a business, you’ll need to file a Schedule C form with your tax return. This form lets you report income and expenses related to your business, including any deductions.
Can the IRS Classify My Business as a Hobby?
No matter how you file your taxes, the IRS can decide to reclassify your business as a hobby. This could happen for many reasons, with a common one being that the business has lost money for years. You can appeal if this happens, but you’ll have to provide thorough records and show that you are actively running a business.
Final Thoughts
If you’re making money from a hobby, determining how the IRS views your activity is crucial. Are you a hobbyist indulging in profitable fun? Or are you a business owner trying to rake in as much profit as possible?
The team at Kondler & Associates, CPAs, can dive into the nuances of your case and make sure your activity is classified correctly. Contact us today to learn how we can help.
