Hobby or Small Business?

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Some of our hobbies are just that – something we do because we enjoy it & we all probably spend more money on the activity, whatever it is, than we’ve budgeted.

But when does a hobby become a business?

Hobby vs. Business

The key factor in answering the business vs. hobby question is whether or not you are doing it to make a profit.

If you are and if you do make a profit, guess what? That income is probably taxable business income.

At the same time, if you are making a profit on your “hobby”, that’s taxable income too. Surprised aren’t you?

So if income from both is taxable, why should you care which way it is classified?

Hobby vs. Business Taxation

From a taxation standpoint, there are some key differences:

• You can deduct business losses against other income, but not losses on hobbies.
• Hobby income is reported under “Other Income” on your personal Form 1040 tax return.
Hobby expenses are deducted on Schedule A, which means you have to itemize deductions in order to do so.
• Since hobby expenses are part of your Itemized Deductions, the expenses are subject to the deduction limitation that the expenses exceed 2% of your Adjusted Gross Income (AGI).
• Business expenses and income are reported on Schedule C, Profit or Loss from a Business. It doesn’t matter if you itemize your other deductions or not.
Hobby expenses are only deductible up to the amount of income you generate from it.
• To deduct hobby expenses, you need to pass the IRS litmus test that you are actually engaging in your hobby to make a profit.

IRS and the Hobby vs. Business Question

Here are some of the questions the IRS uses to decide if it is a business:
• Is your “hobby” carried on in a businesslike manner?
• Does the time and effort you put into the “hobby” show that your intention is to generate a profit?
• Do you depend on income from the “hobby” for your livelihood?
• Are your losses are due to circumstances beyond your control (or normal in the startup phase of your type of business)?
• Do you adjust your operations to improve profitability?
• Do you have the knowledge required to operate this “hobby” as a successful business?
• Have you been successful in making a profit in similar activities in the past?
Does the “hobby” make a profit in some years and how much profit does it make?
• Can you expect to profit from the future appreciation of the assets?

Still not sure?

If you want to delve into this more extensively, consult your financial advisor or check out the information in IRS Publication 535 “Business Expenses”.

Whatever the business vs. hobby determination for tax purposes, have some fun doing it.

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