Understanding Hobby Income and Losses: Tax Advice

Smart Tips on Differentiating between Hobby and Business Income

Key Points

  1. Hobby income rules are in place to prevent taxpayers from claiming excess losses on their tax return for activities with no intention of making a profit.
  2. Hobby income is required to be reported on your tax return, but you can’t take any deductions unless the activity is a business.
  3. There are ways you can ensure your business is not classified as a hobby by the IRS.

Table of Contents

  1. Differentiating Between Hobby and Business Income
  2. How Does the IRS Treat Hobby Income and Loss?
  3. How Can You Ensure Your Business Isn’t Classified as a Hobby
  4. Reporting Hobby Income vs Business Income
  5. Conclusion

Are you considering turning a hobby into a full-fledged business? If so, it’s important that you understand hobby income and loss regulations to avoid the IRS nixing your deductions and assessing you back taxes.

In this article, we’ll cover everything you need to know about hobby income and loss, including the difference between a hobby and a business, how the IRS calculates taxes, and steps you can take to prevent your business from being classified as a hobby.

1. Differentiating Between Hobby and Business Income

The IRS treats hobby income differently than business income. The primary purpose of running a business is to make a profit, while a hobby is geared toward pleasure or recreation. The IRS outlines a set of questions you can ask yourself to determine if you are running a business or engaging in a hobby.

• Do you carry out the activity in a businesslike manner and keep complete and accurate books and records?
• Does the time and effort you put into the activity show you intend to make a profit?
• Does the activity make a profit in some years – if so, how much profit?
• Can you expect to make a future profit from the appreciation of assets used in the activity?
• Do you depend on income from the activity for your livelihood?
• Are any losses due to circumstances beyond your control, or are the losses normal for the startup phase of your type of business?
• Do you change your methods of operation to improve your profitability?
• Do you have the knowledge needed to carry out the activities as a successful business?

If you answered yes to any of these questions, you are running a business. Another way you can tell how your activity is classified is to look at money coming in. If you receive a 1099, you are most likely running a business.

2. How Does the IRS Treat Hobby Income and Losses?

The IRS requires taxpayers to report all income, regardless of if it’s derived from a hobby. This means that selling quilts may require you to pick up extra income on your tax return. However, unlike business income, hobby income isn’t subject to self-employment taxes.

Hobby losses are not deductible. The IRS will allow you to increase your taxable income through hobby income but not reduce your liability by reporting losses. For example, if you sold $350 worth of quilts and you paid $50 for crafting materials, you would not be able to lower your income. Instead, you will need to report the full $350 of hobby income.

Unlike hobby income, businesses reported on Schedule C of the 1040 are required to pay self-employment taxes on net profits. This rate is 15.3%, resulting in a significant tax burden. Even if your hobby is considered a business for tax purposes, you are usually exempt from self-employment taxes if you make under $400.

Taxpayers who want to claim hobby expenses must report the hobby income as business income on Schedule C. Keep in mind that just because you classify your hobby income as business income doesn’t mean the IRS will agree. This can be risky, especially if you claim excess losses on Schedule C.

Furthermore, hobby income reported on Schedule C as business income is subject to self-employment taxes. However, if you have a net loss, you aren’t required to pay self-employment taxes and may be able to reduce your tax liability by offsetting other income streams.


Case 1.

Facts:

Mary loved to sew, and she especially had fun with quilts, so she decided to set up a shop, eZ Quilts. She’s been quilting for 5 years. Over those years, Mary has claimed her quilting business as a business on her taxes. For the first 2 years, she did not make a profit. In the third and fourth years, she did bring in some money from the sales of quilts. This year, Mary is hoping to make a profit again so that her blog isn’t classified as a hobby.

Mary’s revenues:
  • Selling quilts
  • Selling quilting patterns
  • Selling quilting kits
  • Giving quilting classes at the local community center
Mary’s blogging expenses:
  • Quilting materials and supplies
  • Ad space at the local magazine
  • Class space at the local community center
  • Auto expenses
  • Etsy Fees
  • Postage
Results:
  • Unfortunately, Mary’s expenses outweighed her income, and she reported another loss. According to the hobby loss rule, her shop is now considered a hobby, not a business.
  • Mary still wants to run her shop like a business and prove her intent to make a profit. Mary opened the bank account in eZ Quilts’ name. She also kept strict records showing her business income and expenses without paying her personal expenses with the business funds. She can submit these to try and still claim her deductions.
  • The IRS will have to determine if Mary’s shop can still be considered a business, but her careful records will help her make a case.

3. How Can You Ensure Your Business Isn’t Classified as a Hobby?

Even if you meet the above criteria for reporting your hobby as business income, there are steps you can take to solidify your position. Having the proper documents and processes to substantiate your position of reporting on Schedule C can help you avoid an unfavorable audit opinion and back taxes.
Here are some steps you can take to ensure your business isn’t classified as a hobby:

1: Separate Business and Personal Expenses

First and foremost, you want to separate business and personal expenses. This is a relatively simple process, requiring a separate business bank account. All business-related transactions, including income, should flow through your business bank account.
This doesn’t mean you aren’t able to access the funds. Instead, you can withdraw money from the account at any time, taking what’s called a distribution. Most financial institutions have business banking options.
Remember, some financial institutions require an employee identification number (EIN) to open a business bank account. Sole proprietorships are not legally separate entities from your Social Security number, but single-member LLCs can apply for an EIN. If you need an EIN, consider forming a single-member LLC in your home state.

2: Follow Clear Accounting and Bookkeeping Policies

Just like it’s important to separate business and personal expenses, it’s also critical to have clear accounting and bookkeeping policies. You should have support for each transaction you report on your business return. For example, if you report $500 in supplies and materials, what makes up that balance?
If you were to get audited, bank or credit card statements aren’t enough documentation. Instead, you need receipts and invoices that break down the amount being charged. It can be helpful to use accounting software to keep track of your transactions.
Additionally, prioritize clean accounting records, such as through monthly reconciliations or working with a qualified accountant. This ensures you are claiming all allowable expenses and reporting accurate income numbers.

3: Use Professional Marketing Materials

Differentiating your business from a hobby relies on pursuing revenue, which can be done with the use of professional marketing materials. Creating business cards or a website is a great way to actively look for income, which is one of the criteria the IRS uses to determine the validity of your business.
Not to mention that marketing materials are a qualifying business deduction, helping you lower your taxable income and prove to the IRS that you are seeking profit. Advertisements that are only through word-of-mouth or personal social media posts look like a hobby, not a for-profit business.

4: Report Profit 3 Out of 5 Years

The IRS uses profit as a rule of thumb to determine whether an activity is a hobby or business. If your business generates losses year after year, it can raise a red flag. At a minimum, you should try to report a profit for at least three out of five years.
It’s important that you prioritize accuracy in your tax filings. You shouldn’t avoid taking qualifying deductions just to generate a profit. Instead, look for legal ways to increase your income, such as by depreciating assets over their useful life rather than using special depreciation options.
If you aren’t able to generate a profit, be sure you have thorough accounting records supporting your expenses and business operations. You don’t want to raise any questions in the event of an IRS audit.

5: Create a Business Plan

Although it might seem like a wasted cost, a business plan can be a great option to prove to the IRS that you are running a business. Your business plan should outline every detail about your business, from who your target customer base is to what kinds of products and services you plan on offering.
Developing a comprehensive plan shows the IRS that you are looking to make a profit and generate revenue. It can also help you stay focused on your main goals and support faster growth.

Explore Other Entity Classifications: It’s much harder to argue that a partnership, s-corporation, or multi-member LLC classification is not a business compared to a sole proprietorship. If you are worried about the IRS considering your business a hobby, explore other entity classifications.
Even though you might be required to file a separate business tax return, certain entity classifications provide a greater legal separation. Talk with a qualified accountant to see if switching entity structures is a viable option.

4. Reporting Hobby Income vs Business Income

Hobby income is reported as other income on the individual tax return. For 2023 returns, this will be found on Schedule 1. Remember, the other income classification is only used for hobby income. You aren’t able to take any expenses when you report hobby income as other income on your return.
If you need to report business income and expenses, you will need to use Schedule C. Both hobby income and business income will be subject to ordinary income taxes, depending on which tax bracket you fall into. However, only income reported on Schedule C will be subject to self-employment taxes.
Sometimes, business owners who are just getting started report business income as hobby income to avoid self-employment taxes. This can significantly increase your audit risk, which is why it’s best to ensure you are reporting income in the proper places.

5. Conclusion

Do you have extra income this year? Can you confidently determine if it’s hobby income or business income? The individuals contemplating the transition of their hobby into a full-fledged business need to learn crucial insights into the distinctions between hobby and business income, the IRS regulations governing such activities, and steps to prevent adverse tax implications.


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