The Internal Revenue Service (IRS) differentiates between hobbies and businesses for tax purposes. Understanding this distinction is important because the tax treatment for each category can vary significantly. Here are some key factors the IRS considers when determining whether an activity is a hobby or a business:
- Engaging in the activity primarily for personal pleasure, recreation, or entertainment.
- Not pursuing the activity with the intention of making a profit.
- Incurring expenses related to the activity but not necessarily expecting to generate income or making a profit.
- Any income generated from the activity is typically reported on Form 1040 as “Other Income.”
- Engaging in the activity with the primary intention of making a profit.
- Demonstrating a consistent and regular effort to carry on the activity.
- Investing time, effort, and resources into the activity with the expectation of generating income or making a profit.
- Deducting business expenses related to the activity to reduce taxable income.
- Reporting business income and expenses on appropriate tax forms, such as Schedule C (Profit or Loss from Business) for sole proprietors.
It’s important to note that simply declaring an activity as a business does not automatically make it one in the eyes of the IRS. They examine the facts and circumstances surrounding the activity to determine its classification. Before hiring a bookkeeper, bookkeeping service, tax preparer or an accountant, make sure that they understand this difference.
Tax implications: Hobby-related expenses are generally not deductible, or they may be subject to limitations. Hobby income is reported as “Other Income” on your tax return but is not subject to self-employment tax.
For a business, you can deduct ordinary and necessary business expenses related to the activity, such as supplies, advertising costs, rent, utilities, and more. Business income is subject to self-employment tax, and additional tax obligations and reporting requirements may apply.
It’s important to consult a tax professional or refer to IRS guidelines (such as IRS Publication 535) for specific details and to ensure compliance with tax laws. They can provide guidance based on your unique circumstances to help determine whether your activity should be classified as a hobby or a business and how to report it correctly on your tax return.