There’s an old Gershwin song that goes, “You say tomato, I say tamahtoe … let’s call the whole thing off.” Taxpayers and the IRS have their own version: “You say hobby, I say business.”
The difference between businesses and hobbies is that you have to prove that your hobby is a business by passing not one but nine tests. It matters because the outcome of the hobby-business tests can have rather serious tax implications.
In a nutshell, the difference between a business and a hobby comes down to how expenses/losses are treated. Business expenses and losses are fully deductible, while the expenses related to a hobby are only deductible up to the amount of any income you earned from your hobby.
Much of the confusion for taxpayers occurs when they classify their hobby as a small business because it generates some income. The IRS definition of a hobby is not entirely helpful, since it classifies a hobby as an activity that you engage in “for sport or recreation, not to make a profit.”
For example, a person who restores classic cars and sells them for a profit should be considered a business, right? Not necessarily. Someone who restores one or two cars a year can be considered a business. On the other hand, someone else restoring and selling six cars a year could still be considered a hobbyist.
The point is, as crazy as that sounds, the difference between a hobby and business is not a matter of volume. It’s all about intent. The following questions, or tests, can help you make the distinction between a hobby and a business:
- The manner in which the taxpayer carried on the activity.
Are you keeping accurate books and using them to improve your performance?
- The expertise of the taxpayer or his or her advisers.
Are you seeking professional guidance to improve your business practices?
- The time and effort expended by the taxpayer in carrying on the activity.
Are you investing enough time to make the business successful?
- The expectation that the assets used in the activity may appreciate in value.
Are you planning to generate a profit from the appreciation of assets?
- The success of the taxpayer in carrying on other similar or dissimilar activities.
Have you gone from being unprofitable to profitable in similar activities?
- The taxpayer’s history of income or loss with respect to the activity.
Have you been profitable in at least three of the past five years for most businesses?
- The amount of occasional profits, if any, which are earned.
Even a small profit earned every year provides strong evidence of a business rather than a hobby.
- The financial status of the taxpayer.
Do you have other sources of income that are being offset by the activity?
- Elements of personal pleasure or recreation.
Does the activity have significant personal elements (indicates a hobby)?
Remember our two auto restorers. The guy who did just two cars a year consistently made a profit from the cars he restored and kept detailed records of what he spent on parts and tools. He paid careful attention to the classic-car market and chose only to restore cars that he knew were in demand.
The restorer who did six cars a year could only estimate his costs and only spent about two weekends a month working on projects. Most years he lost money largely because he chose to restore cars that he found interesting. Many of the cars he restored didn’t appreciate in value year over year even when fully restored.
Deducting Hobby Expenses
If it turns out that what you thought was a side business is really a hobby that generates income but not a profit, you can still deduct some or all of your expenses, which means there’s a good chance you won’t owe taxes on the income you earn.
In order to deduct hobby expenses, you must itemize your deductions (complete a Schedule A). The IRS has three categories of expenses that you can deduct, and they must be used in order and only to the maximum allowed by each.
- Deductions that a taxpayer may take for personal as well as business activities, such as home mortgage interest and taxes, may be taken in full.
- Deductions that don’t result in an adjustment to basis of property, such as advertising, insurance premiums, and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
- Business deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.
The IRS’s enforcement of hobby loss rules means that if you truly are operating a side business, you need to treat it like a business, and be prepared to prove your claim to an IRS representative. Perhaps the surest way to have even a legitimate business — one that meets eight of the nine criteria for a business — considered a hobby is to have consistent losses year after year. The IRS views this as the biggest indicator that a business is actually just a hobby.