Updated: Jun 19
Did you start a side project that blossomed into a hobby that expanded into your friends asking for you to do/make stuff for them? Happens to the best of us. Thankfully, this is a good problem to have and we’re going to discuss how to differentiate a hobby from a business and how to avoid paying more in tax with your hobby or business. While the two can sometimes overlap, it's important to understand the differences between them to avoid running afoul of the IRS' hobby loss rules.
What is considered a ‘hobby’?
According to the IRS, a hobby is an activity that is "not pursued for profit." In other words, if you engage in an activity primarily for personal enjoyment or satisfaction, and not to make money, it is likely a hobby.
What is considered a ‘business’?
On the other hand, a business is an activity that is conducted with the intention of making a profit. It can be a sole proprietorship, partnership, or corporation, and can involve selling products or services to customers.
Hobbies versus businesses
One of the key differences between a hobby and a business is the intention to make a profit. If you engage in an activity with the goal of making money, it is likely a business. However, if you engage in an activity primarily for personal enjoyment, and any money you make from it is incidental, it is likely a hobby. This is not to say that you cannot turn your hobby into a business.
Whether you have a hobby or a business that makes money, you still have to report that income on your tax returns. If it’s a hobby, you will have very specific tiered deductions you can take (due to the 2017 Tax Cuts & Jobs Act (TCJA)). If it’s a business, you can write off your business expenses like any other business would.
It’s important to remember that there are several factors the IRS considers when determining whether an activity is a hobby or a business. These include the manner in which the activity is conducted, the expertise of the taxpayer or their advisors, and the time and effort expended on the activity.
What happens if your business is classified as a hobby?
If the IRS determines that your business is actually a hobby, you may be subject to the hobby loss rules. Before the 2017 TCJA, taxpayers were allowed to deduct hobby expenses as an itemized deduction on Schedule A, subject to a 2% floor of adjusted gross income (AGI). In other words, only the portion of hobby expenses that exceeded 2% of the taxpayer's AGI could be deducted.
However, the TCJA suspended the miscellaneous itemized deductions subject to the 2% floor, including hobby expenses, for tax years 2018 through 2025. As a result, under the current law, hobby expenses are generally not deductible on your federal income tax return.
Best practices to avoid being classified as a hobby
To avoid having your business classified as a hobby, there are several best practices you can follow:
Keep accurate and detailed records of your business activities and expenses.
Have a business plan that outlines your goals and strategies for making a profit.
Invest sufficient time and effort into your business to demonstrate your intention to make a profit.
Seek professional advice from a tax or legal expert.
In conclusion, understanding the differences between hobbies and businesses is important for anyone looking to make money from an activity. By following best practices and demonstrating your intention to make a profit, you can avoid having your business classified as a hobby and facing the limitations of the hobby loss rules. Always seek professional advice from a tax or legal expert to ensure compliance with IRS regulations. Schedule a free consultation today.