A lot of small businesses start out as hobbies. After time and growth, the entrepreneur slowly starts devoting more time to the endeavor and it gradually grows into a full-fledged business. These are the success stories that motivate many people to strike out on their own.
Unfortunately, many “small businesses” never grow to this level and are considered a hobby for tax purposes. This isn’t necessarily a bad thing. In fact, many hobbies are successful in that they break-even or make a little extra money from time to time.
Just to be clear, the whole point of this post is to help illustrate the differences between a hobby and a small business and to explain some of the tax consequences of having your activity be treated as a hobby.
What is the difference between a hobby and a small business?
The primary distinction for tax purposes between a hobby and a small business is what has become known as the “Profit Motive.” This profit motive can be hard to determine and must be evaluated for each business activity, especially when there are losses involved with the activity.
The Internal Revenue Code Section 183 states there is a presumption of having a profit motive in the activity if you have net income for the activity for 3 or more of the taxable years in a period of 5 consecutive taxable years. This means, if you activity is able to generate a profit for 3 out of 5 years, you can most likely consider it a small business and report all your income and deductions on Schedule C, Profit or Loss from Business.
The US Treasury has also come out with regulations that have 9 factors that the IRS can use to determine whether a specific activity is a hobby. See Reg Section 1.183-2
- Manner in which the taxpayer carries on the activity.
(Does the time and effort put into the activity indicate an intention to make a profit?) - The expertise of the taxpayer or his or her advisors.
(Do you have the knowledge to carry on the activity as a successful business?) - The time and effort expended by the taxpayer in carrying on the activity.
(Does the time and effort put into the activity indicate an intention to make a profit?) - Expectation that assets used in the activity may appreciate in value.
(Do you expect to make a profit in the future from the appreciation of assets used in the activity?) - The success of the taxpayer in carrying on other similar or dissimilar activities.
(Have you made a profit in similar activities in the past?) - The taxpayer’s history of income and losses with respect to the activity.
(Does the activity make a profit in some years?) - The amount of occasional profits, if any, which are earned.
(Do you make an occasional profit but tend to have large losses in relation to the amount of investment in the activity?) - The financial status of the taxpayer.
(Do you depend on the income from the activity?) - Elements of personal pleasure or recreation.
(Do you only participate for personal pleasure or recreation rather than trying to earn a profit?)
The factors above are not all-inclusive and other factors could be used. However, they are helpful in determining whether your activity is an activity engaged in for a profit or as a hobby.
Why does the distinction between a hobby and small business matter?
The tax rules around hobbies and small businesses are completely different. A small business reports all its profits and losses on Schedule C of the owner’s Form 1040, Individual Income Tax Return. If there is a loss, the individual is allowed to recognize this loss and use it to off-set other income on the return. If there is net income from this activity, the income is taxed as ordinary income and is also subject to self employment taxes.
However, for a hobby, the income and related expenses are reported differently. To start, the income is reported on page one of Form 1040 using line 21. This line is for “Other Income.” The full amount of income goes on this line, meaning it is not netted against any expenses of the activity. The expenses get reported on Schedule A, which is used for itemized deductions. These expenses are characterized as Miscellaneous Itemized Deductions and they are subject to the 2% of adjusted gross income limit. In addition to being treated as an itemized deduction subject to the 2% AGI limit, the amount of deductions can not exceed your hobby income. This means you can’t have a net loss on your tax return for your hobby.
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Important update
The Tax Cuts and Jobs Act of 2017 has removed the ability to deduct miscellaneous itemized deductions for tax years 2018 through 2025. There’s no telling what will happen with Tax Reform 2.0 but it is likely this will be made permanent.
In summary, a small business is allowed to deduct all its related expenses and the net amount of income or loss is allowed on the tax return. For a hobby, all the revenue income is taxed but the expenses are limited (for 2017 and earlier years) or are disallowed (for tax years 2018 – 2025). This distinction might be enough to motivate you to turn your hobby into a small business.
Final thoughts and considerations on hobbies
There’s nothing wrong with having a hobby. In fact, many people receive a lot of enjoyment and personal fulfillment by participating in hobbies. The point of this post is to illustrate some of the differences between a hobby and a small business so you can know, ahead of time, how you’ll be taxed on the income from your activities. Particularly, if you determine that you’re participating in a hobby, don’t go spending a lot of money just because you think you can deduct it. There’s nothing worse than having to tell a client that all this money they spent is not deductible because their activity is a hobby.
There is an opportunity to plan for this and, if you really enjoy the activity, turn it into a small business by establishing proof that you’re trying to earn a profit. You do this by using the list above to figure out what you can add to your activities to create a verifiable profit motive.
This post is not intended to give tax advice. As you can see from the above list of factors, each activity is unique and has must be looked at individually. There is a ton of information out there to help learn more about this topic. In addition, any tax professional should be able to answer your questions about hobby losses and how to classify the activity. If you have specific questions, please feel free to contact me. In fact, I encourage you to follow me on Twitter at @cbriancpa so you can learn more and join in discussions of hot tax topics.
For more information see these resources:
- See the Journal of Accountancy – From the Tax Adviser article “Profit motive key in hobby loss cases.”
- The IRS has a publication that addresses hobby income and expenses in Publication 535.
- Recent Developments in Individual Taxation from the Tax Adviser, September 2018.