Hobby or Business: Why it Matters for Taxes
Do you have a hobby or a side-hustle business? While you may not think much between the two, it does make a difference when it comes to filing taxes. Income from a hobby differs from other types of income. Examples of this would include self-employment/business income (i.e., side hustle). Thus, the IRS will tax each type differently.
Determining if your hobby is a business is not always easy, so it is important to know the income type and how to claim it on your tax return. Reporting your income incorrectly can lead to delays in processing and even tax penalties. At Hardie CPA, we want to help explain the difference so you can maximize your return. Here are some quick tips to help you determine if your hobby is a business.
Hobby or Business?
The biggest difference between a hobby and a business is that a business operates to make a profit while hobbies are for pleasure or recreation. But hobbies can also make income. So, let’s sort out the two.
Below are some questions to help you decide if you have a hobby or a business:
Does the time and effort put in show intentions to make a profit?
Does the activity make a profit over the years? Are you putting in resources or changing methods of operation to improve profitability?
Do you depend on the income from the activity for your livelihood?
Do you change the methods of operation to help improve the profitability?
Do you keep books and records to assist you in running the activity?
Do you hire qualified employees to help you?
Do you a advertise to get customers?
or
Does the activity have recreational aspects?
Are there personal motives behind the activity? If you like the activity or find it relaxing it may be viewed more as a hobby.
Are there other sources of income that can prove your activity is more of a hobby and not a financial necessity?
Has the activity produced a profit in at least three out of the last five years? A series of profitable years tends to support business classification. Ultimately, the determination is based on all relevant facts and circumstances surrounding the activity.
When a Hobby Becomes a Business
If you have discovered an enjoyable and profitable activity, you can turn your hobby into a business. With a business, you can take deductions that will reduce your taxable income.
A business can deduct things such as travel expenses, items purchased to help run the business, Internet expenses, a home office, etc. from their sales revenue. See: What’s Tax Deductible for your Business. A business can also generally produce a deductible loss (if the year was not profitable), whereas a hobby cannot.
While some good perks can come along with claiming and deducting business expenses (and losses), you need to be prudent as well. If the IRS suspects you are deducting losses from a hobby rather than a business, you could face an audit and risk losing the ability to deduct those losses, which will increase your tax bill.
How to Report
Hobby: Even if you decide your activity is a hobby, you will still need to report any income, but the good news is there is less tax preparation! The income would be reported as Additional Income on your Form 1040. This income will not be subject to self-employment tax, but also remember you can not deduct any expenses associated with your hobby.
Business: If you are reporting income from a business, you will need to report your income and expenses on Schedule C of Form 1040. You will pay self-employment tax on your earnings, but you may also deduct qualified business expenses.
In Conclusion
While many aspire to turn their hobbies into successful businesses, it is important to ensure compliance with IRS regulations. As stated, there can be a lot of advantages to owning a business, but if it is truly not a business and just a hobby, there can be penalties as well.
When in doubt, reach out to Katie Hardie, CPA. She can walk you through the best course of action to help you make the most of your tax return.
Katie Hardie, CPA is the owner of Hardie CPA and a member of the American Institute of Certified Public Accountants. She has a full range of experience as a CPA - including tax, bookkeeping & audit. Her experience spans both public and private accounting. Her passion is helping small businesses & individuals with tax & accounting needs. Katie seeks to empower small-business owners in the area of bookkeeping & tax so that they can stay on track, focus on their bottom line and grow their business. She works virtually and can be reached at katie@hardiecpa.com or click here to fill out a contact form.
Hardie CPA provides the information in this article for general guidance only. It is not intended to nor does it constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your situation. Tax articles in this blog are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.