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When a hobby becomes a business: 9 key factors

There’s a saying that everyone should have three hobbies: one to keep you in shape, one to keep you creative, and one to make money.

Many people have found hobbies that make money. In fact, a 2019 survey found that 27% of full-time workers have monetized their hobbies. Another 55% said they would like to turn their hobby into a business, and interest in building a “side hustle” has only grown since then.

With millions of Americans now monetizing their hobbies, it’s important to understand how a side hustle could affect your taxes.

Hobby or business?

Hobby and business tax rules are different and it’s important to understand the distinctions to avoid any potential issues with the IRS. So, at what point does your money-making hobby become a business in the eyes of the IRS? There’s no checkbox for you to claim one way or the other. The main differentiator comes down to motive. Businesses have a goal of earning a profit, while hobbies are activities that are pursued for personal enjoyment.

Here are nine more factors the IRS may consider when determining if your side hustle is a business or a hobby:

  1. Does the activity make a profit in some years? How much profit does it make?
  2. Were you, as the taxpayer, successful in making a profit in similar activities in the past?
  3. Do you and your advisors have the knowledge needed to carry out the activity as a successful business?
  4. Do you change methods of operation to improve profitability?
  5. Does the time and effort you put into the activity show that you intend to make it profitable?
  6. Was the activity carried out in a businesslike manner, and did you maintain complete and accurate books and records?
  7. Do you depend on income from the activity for your livelihood?
  8. Can you expect to make a future profit from the appreciation of the assets used in the activity?
  9. Are any losses due to circumstances beyond your control, or are they normal for the startup phase of your type of business?

What are the tax differences?

Businesses are required to file an annual business tax return and report all income earned. They can also deduct expenses related to their business activities, such as rent, supplies, and salaries paid to employees. Hobbyists are still required to report any income they made through their hobby on their individual tax returns, but hobby expenses are no longer deductible.

Another key difference is that businesses can carry forward losses incurred in previous years to offset future profits, while hobbyists can’t. Additionally, businesses may be subject to additional taxes, such as self-employment tax, but income from hobbies is not.

Be aware: if your business isn’t profitable and you’ve claimed a loss for too many years, the IRS could consider it a hobby and prevent you from claiming a loss or deducting expenses. In that case, you’d need to prove that profit was the intent in order to claim business deductions.

That’s also where the safe harbor rule comes in. Typically, if your business has been profitable in at least three out of five consecutive years, that’s a signal to the IRS that it’s a valid business, not a hobby.

Making a hobby into a business

If you want to be seen as a business rather than a hobby, it can help to follow best practices like:

  • Setting up a business checking account
  • Separating personal and business expenses
  • Keeping good business records
  • Choosing the appropriate entity structure for your business
  • Staying in compliance with other state and federal tax laws, such collecting sales taxes
  • Having regular business hours
  • Maintaining a business website and/or social media accounts

If you need help determining how you qualify or are looking to grow your business, Padgett’s network of EAs, CPAs and business advisors can help! Find a location near you today.

We encourage you to contact us with any questions.

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