Many people do not realize that the IRS has different rules for a hobby versus a business. In fact, the IRS has lengthy regulations they use to decide whether an activity is a hobby or a business. Why would the IRS care if you have a hobby or a business? Because the income tax rules for each are very different! If you have a hobby according to IRS guidelines, then you must report any income you receive from your hobby. However, any expenses you incur are not deductible under the current tax law (the Tax Cuts and Jobs Act).
What is a hobby
IRS regulations list nine factors they consider when deciding if an activity is a hobby or a business. All facts and circumstances of the taxpayer and the activity must be considered. No one factor is more important than the other. Instead, by evaluating all factors together, you reach a conclusion one way or the other. Here are the nine factors:
1. Whether the activity is carried out in a businesslike manner and the taxpayer maintains complete and accurate books and records.
2. Whether the time and effort the taxpayer puts into the activity shows they intend to make it profitable.
3. Whether they depend on income from the activity for their livelihood.
4. Whether any losses are due to circumstances beyond the taxpayer’s control or are normal for the startup phase of their type of business.
5. Whether they change methods of operation to improve profitability.
6. Whether the taxpayer and their advisors have the knowledge needed to carry out the activity as a successful business.
7. Whether the taxpayer was successful in making a profit in similar activities in the past.
8. Whether the activity makes a profit in some years and how much profit it makes. The IRS expects businesses to earn a profit for at last three out of every five years. A business that does not meet this profit threshold is presumed to be a hobby.
9. Whether the taxpayers can expect to make a future profit from the appreciation of the assets used in the activity.
Here is an example
Most people start hobbies for enjoyment. They don’t intend to make money from it at the beginning. I have friends who have taken up pottery, woodworking and painting. They wanted to learn something new and see if they enjoyed it. As they got better, they would give items they made as gifts to friend and family. Over time word spread and people began requesting to purchase items from them. My friend would agree to make something and just charge for the cost of materials. This is a classic example of a hobby, where any money you collect is taxable income and none of your costs are deductible. This is how the hobby you love could be taxable.
Here is where it gets interesting! One of my friends turned out to be very good at their hobby – pottery. People encouraged him to start selling his pieces. Recently he opened an ETSY store and printed out business cards and has even sold a couple pieces. He has a full-time job and the money from his pottery is not enough to support him. Many people call this a side gig. I would argue at this point he has a side “business”. At the point he put his items up for sale to the general public, he moved from a hobby to a business. He needs to expand it and demonstrate that he can make a profit. But he is clearly selling items and is working to develop more pieces he can put up for sale.
Now you know the hobby you love could be taxable. It is hard to give clear cut answers on an issue that the IRS views as a matter of facts and circumstances. That is inherently subjective and different people can reach different conclusions. But knowing the nine factors to consider and analyzing them based on the facts of your situation should enable you to make a conclusion on whether you are engaged in a hobby or a business.