I love to draw. As long as I could remember, I would always doodle in
class my spare time.
The thought of creating and selling artwork on the side has crossed my mind multiple times, and I was always faced with the same questions: How much time would I put into it? Where and how would I sell it? Would I become attached to it and not even want to sell it? How long do I expect to operate?
The answers to these questions could determine whether I’m running a business or what the IRS calls a “hobby”. The distinction is important because the tax implications are very different (more on this later).
9 Factors That Determine Whether You Have a Business or a Hobby
The IRS lists nine factors to help distinguish between a business and a hobby:
- Whether you carry on the activity in a businesslike manner. Do you keep accurate books and records? Do you have a separate bank account and credit card for the activity? Having business cards and spending money on advertising are examples of indicators that the activity is not a hobby.
- Whether the time and effort you put into the activity indicate you intend to make it profitable. Do you put a lot of your personal time and effort into the activity in order to succeed and generate profit?
- Whether you depend on income from the activity for your livelihood. Does the income of the activity greatly aid in supporting you and your family? Do you have other income sources which would be reduced by business losses? That could be a red flag leading the IRS to think that a major motive of an activity reporting losses is simply to reduce other elements of your income.
- Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business). What’s causing the losses? It’s normal for a business to operate at a loss for the first few years of operation. Losses in a random year here and there due to unforeseen events are common, too. Reporting losses on a consistent basis is where you can run into trouble.
- Whether you change your methods of operation in an attempt to improve profitability. Are you changing your business plan or strategy to improve your unprofitable activity and turn a profit? An example would be increasing your marketing budget.
- Whether you or your advisors have the knowledge needed to carry on the activity as a successful business. Are you experienced in the area of business of the activity? If not, do you consult with experts and other professionals?
- Whether you were successful in making a profit in similar activities in the past. Have you started other businesses? If so, have you improved an unprofitable business to make it profitable?
- Whether the activity makes a profit in some years and how much profit it makes. Have you been profitable in three out of the last five years? The “3-of-5 Test” is a popular test used by the IRS to determine if the activity is a business operating with the intent to make a profit. Any profit, no matter how small, is a good indicator of a business.
- Whether you can expect to make a future profit from the appreciation of the assets used in the activity. Do you plan to profit from the activity’s assets in the future? This eliminates purchasing personal “assets” strictly for write-offs.
As briefly mentioned above, the tax implications of income and losses differ greatly between a business and a hobby.
- Income and expenses are reported on Schedule C
- Net income is subject to self-employment tax
- Losses reduce total income
- Gross income is reported on Form 1040, Line 21 – Other Income
- Expenses are reported on Schedule A, Line 23 – Other Miscellaneous Deductions (Subject to 2% of your Adjusted Gross Income), meaning they do not directly reduce your hobby income; in order to get a benefit, you must itemize and, even then, your deductions must exceed 2% of your AGI
- Income is not subject to self-employment tax
- Losses are disallowed; deductions are limited to the extent of income generated by the hobby
So, Business or Hobby?
Clearly, there is no hard and fast rule to determine whether you have a legitimate side business or a hobby. If you answered the above questions and are still unsure as to which category your activity falls under, comment below or reach out directly and I’ll help you “draw” a conclusion (I told you, I love to draw).
PS – You know when you repeat a word so often in such a short period of time and it starts to sound weird? Like, you question if it’s really even a word? I think “hobby” is a permanent one for me now. Hobby… Hobbies… Weird!
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Nick Aiola is a CPA and the owner of Aiola CPA, PLLC. Nick and his team provide the highest quality of tax and advisory services to real estate investors and individuals and business owners in the real estate industry.
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