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.
BUSINESS | versus | HOBBY |
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.