When you incorrectly claim your favorite hobby as a business, it’s like waving a red flag that says “Audit Me!” to the IRS. However, there are tax benefits if you can correctly categorize your activity as a business.
Why does hobby versus business activity matter?
Chiefly, you’re allowed to reduce your taxable income by the amount of your qualified business expenses, even if your business activity results in a loss.
On the other hand, you cannot deduct losses from hobby activities. Hobby expenses are treated as miscellaneous itemized deductions and don’t reduce taxable income until they (and other miscellaneous expenses) surpass 2 percent of your adjusted gross income.
Here are some tips to determine whether you can define your activity as a business.
|You have a reasonable expectation of making a profit.||Profit Motive||You may sell occasionally, but making money is not your main goal.|
|You invest significant personal time and effort. You depend on the resulting income.||Effort and Income||It’s something you do in your free time; you make the bulk of your money elsewhere.|
|Your expenses are ordinary and necessary to run your business.||Reasonable Expenses||Your expenses are driven by your personal preferences and not strictly necessary.|
|You have a track record in this industry, and/or a history of making profits.||Background||You don’t have professional training in the field and have rarely or never turned a profit.|
|You have multiple customers or professional clients.||Customers||You have few customers, mainly relatives and friends.|
|You keep professional records, including a separate checkbook and balance sheet; you have business cards, stationery and a branded business website.||Professionalism||You don’t keep strict professional records of your activities; you don’t have a formal business website or business cards.|
The IRS will consider all these factors to make a broad determination whether you operate your activity in a businesslike manner. If you need help ensuring you meet these criteria, reach out to schedule an appointment.