IRS classifies your business a hobby

Millions of people enjoy hobbies that are also a source of income. From catering to cupcake baking, crafting homemade jewelry to glass blowing -- no matter what a person’s passion, the Internal Revenue Service offers some tips on hobbies.

Taxpayers must report on their tax return the income earned from hobbies. The rules for how to report the income and expenses depend on whether the activity is a hobby or a business. There are special rules and limits for deductions taxpayers can claim for hobbies. Here are five tax tips to consider:

If your business claims a net loss for too many years, or fails to meet other requirements, the IRS may classify it as a hobby, which would prevent you from claiming a loss related to the business. If the IRS classifies your business as a hobby, you'll have to prove that you had a valid profit motive if you want to claim those deductions.

The Internal Revenue Service allows you to take a tax deduction for legitimate losses incurred in the operation of your business. However, if your business claims a net loss for too many years, or fails to meet other requirements, the IRS may classify it as a hobby, which would prevent you from claiming a loss related to the business. If the IRS classifies your business as a hobby, you'll have to prove that you had a valid profit motive if you want to claim those deductions.

Earning a profit

The IRS expects that if you start a business, you intend to make money at it. If you don't, your business is likely to be a hobby. To determine if your business is a hobby, the IRS looks at numerous factors, including the following:

  • Do you put in the necessary time and effort to turn a profit?
  • Have you made a profit in this activity in the past, or can you expect to make one in the future?
  • Do you have the necessary knowledge to succeed in this field?
  • Do you depend on income from this activity?
  • Are your losses beyond your control?

As you might expect, the IRS distinguishes between legitimate businesses and hobby activities, for the purpose of taxes. If you are legitimately in business, you can deduct the expenses of that business and possibly take a loss if your business isn't profitable. If you are not in business to make a profit, the IRS considers your activity as not-for-profit for sport or recreation (that is, a hobby), and it says you cannot deduct expenses to get a loss to offset other income.

Many legitimate businesses start out with a loss their first few years. But the IRS expects that a legitimate business will be set up to make a profit, not just have a hobby. Unfortunately, some people start "businesses" that are really hobbies just to claim the expenses and the loss on their tax returns.

One example is an artist who wants to claim expenses as business-related. The artist (a painter, for example) must show that they are following good business practices and that they intend to make a profit.

Is This Activity a Business or a Hobby?

A legitimate business, according to the IRS, does the following:

  • Has a primary purpose of "income or profit"?
  • Is engaged in "with continuity and regularity"?

The IRS has a list of 9 factors to be used in determining whether an activity is a legitimate business or a hobby:

  1. Whether you carry on the activity in a businesslike manner and maintain complete and accurate books and records.
  2. Whether the time and effort you put into the activity indicate you intend to make it profitable.
  3. Whether you depend on income from the activity for your livelihood.
  4. Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
  5. Whether you change your methods of operation in an attempt to improve profitability.
  6. Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
  7. Whether you were 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.
  9. Whether you can expect to make a future profit from the appreciation of the assets used in the activity.

The IRS looks at every business on a case-by-case basis, depending on the situation.

Can a Corporation Have a Hobby Loss?

Because a corporation is a separate business entity, the IRS does not recognize the "hobby loss" rules for corporations. Because S corporation profits and losses are part of personal tax returns, the "hobby loss" rules do apply.

Will the IRS Consider My Business a Hobby?

There is no place where you designate the deductions from your activity as a business or hobby. It's the IRS that determines if your activity is a business or a hobby. This doesn't happen unless the IRS makes a determination on your business, based on years in business and profitability.

What If My Business Doesn't Make a Profit?

The IRS presumes an activity to be a business (to be set up to make a profit) if it has a profit in at least three of the last five years. The business must be substantially the same during that time. But what if it doesn't? The IRS can review your business situation and make a determination on whether it's for-profit or not-for-profit.

Postponing IRS Determination on Your Business Case

You may want the IRS to postpone making a determination on whether your activity is for-profit or not-for-profit, by making an election, to give you a longer time to make a profit. Use Form 5213 for this purpose." You should make this election within three years after the due date of your return for your first tax year for this activity. So, if you started your business in January , you should make this election before the end of NaN.

The advantage of making this election is that the IRS will not immediately question whether your business is for-profit or not-for-profit. It gives you two more years to show a profit. But, if you don't have the required years of profit, the limit can be applied retroactively to any year with a loss in the five-year period.

Intending to make a profit and be considered a legitimate business also includes good business practices such as:

  • Setting up a separatebusiness checking account
  • Keeping business and personal expenses separate
  • Maintaining a good >business record-keeping systemtnership.
  • Complying with other state and federal tax laws, including collecting sales taxes and paying annual state business renewal fees or franchise taxes.
  • Having regular business hours or maintaining a business website.

In addition to helping legitimize your business in the eyes of the IRS, these activities are important for every business.

How Do Expenses Get Deducted for a Business and a Hobby?

A business would file its taxes on a business tax return. For most small businesses, that means filing a Schedule C for business income. The net income from the business is then included on the individual's personal tax return. If your business is an LLC or partnership or S corporation, you would prepare a tax return for that business and take the resulting income over to your personal tax return.

Expenses for hobby activities may be included with other itemized deductions on Schedule A ,but you may not deduct expenses in excess of income.

Practical standard for business classification

The general rule is that if you have not turned a profit in at least three of the prior five years, the IRS will categorize your business as a hobby. This may be extended to a profit in two of the prior seven years in the specific case of horse training, breeding or racing. This is, presumably, because these endeavors involve a great amount of risk.

Consequences of hobby classification

Generally, the IRS classifies your business as a hobby, it won't allow you to take any losses. However, in certain limited situations you can use your hobby expenses to reduce your taxes.

If you have a hobby loss expense that you could otherwise claim as a personal expense, such as the home mortgage deduction, you can claim those expenses in full.

For tax years prior to 2018, other expenses, such as advertising, wages, insurance premiums, depreciation or amortization, may also be usable as an miscellaneous itemized deduction subject to 2 percent of your adjusted gross income. However, you must have earned more total income in your hobby than the amount of all of these deductions, including your personal deductions. In that scenario, it's likely the IRS would categorize your hobby as a business anyway.

For tax years after 2017, miscellaneous itemized deductions are no longer deductible and therefore no hobby expense is able to reduce hobby income.

Preventing your business from being classified as a hobby

Running a hobby as a business could very possibly trigger an IRS audit. If your business is legitimate, keeping accurate and extensive records could help prevent the classification of your business as a hobby.

In addition to demonstrating your professional approach to your business, records and receipts can help document your profit motive. A written business plan is often a prerequisite for indicating an intent for profit, and it can also show ways in which you are modifying your business to cope with losses.

10 Tips To Turn Your Hobby Into A Business

Whether it's a lazy day of fishing or an afternoon of baking, our hobbies bring us joy and rejuvenate us after a long work week. It's only natural to daydream about turning a hobby into a full-time business, but to create a successful business, you need more than just skills and passion. Building a sustainable business takes planning, commitment, and a business attitude.

Here are some tips on how to get started.

1. Know Your Goal.

Do you want a full-time business so you can quit your day job? Or are you just looking for a little extra cash to cover expenses? The more you'll depend on the income from your hobby-business, the harder you'll need to work at it.

2. Brainstorm all the ways you could make money from your hobby.

You may need to do more than one thing to create a financially sustainable business. For example, if you're a quilter, you could sell your quilts, but you also could teach quilting classes, open a quilting shop, or design and sell quilting patterns.

3. Be sure you'll still enjoy your hobby if you're doing it for money.

Making money from your hobby may mean meeting deadlines, pleasing demanding customers, and doing your hobby even on days when you don't feel like it. You'll have to manage marketing and finances. Be sure you're willing to juggle all these balls before you turn your hobby into a business.

4. Get really good at what you do — before you quit your job.

To make money from your hobby, you've got to be good at it. If your skills aren't yet up to par, make a plan for improving them and put off your business idea until you're ready.

5. Write a business plan.

When you write a business plan, you'll evaluate the market for your hobby-business and prove to yourself that it's a viable business idea. You'll learn how much money you need to get started, you'll set goals, and you'll plan how you'll market the business to your customers.

6. Adopt a business mindset.

A hobby is something you do at your leisure. When you make it a business, you must show up to work. Think of your hobby as your second job and make it a priority in your life.

7. Learn about marketing.

You can be the best in the world at what you do, but if you don't market your business, you'll never get customers. Read up on small business marketing and observe how similar businesses promote themselves. Set up a website for your new business and get comfortable using social media. Start making connections online and in your community.

8. Create a brand and stick to it.

Your brand is your business identity and what you'll be known for. A strong brand helps your loyal customers recognize you, just as people instantly know that golden arches mean McDonald's. Decide on a business name, logo, font, and/or color scheme that reflect your business's “personality" and use them consistently in your website, social media, and other marketing.

9. Get your first customer — even if you have to work for free.

Your first customer will give you confidence in your business idea and will make it psychologically easier to market yourself. If necessary, do your first job for free in exchange for a nice review or testimonial.

10. Put your finances in order.

You must report your business income and expenses on your tax return and pay quarterly estimated taxes. You may also be required to collect sales tax. The easiest way to keep your business finances straight is to set up a bank account for your business, to keep business and personal finances separate. Meeting with an accountant and investing in accounting software can help you started on the right foot.

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