For many Americans, pursuing their passions or hobbies is more than just a pastime – it’s a way to earn a little extra money on the side. Whether it’s painting, writing, cooking or photography, there may be opportunities to generate income from these and other activities that interest you.
But keep in mind that once you receive money for any goods or services you provide, Uncle Sam will have a vested interest in your activities. You are required by law to report this income on your federal income tax return, where it may be subject to income tax.
Business or Hobby – An Important Distinction
The specific tax treatment of income generated from activities like these depends on the answer to a critical question: Is your activity considered to be a business or a hobby by the IRS? Different rules will apply to the way that you report income and expenses based on this distinction.
The IRS lists a number of different factors you should consider in order to determine whether you are running a business or just practicing a hobby. Your activity is more likely to be considered a business if any or all of the following apply:
- The time and effort you spend on the activity indicate your intention to make it profitable.
- You rely on income from the activity to support your livelihood.
- You perform the activity in a business-like manner.
- Any losses sustained in performing the activity are due to circumstances beyond your control, or they are attributable to the startup of businesses similar to yours.
- You have changed how you operate in an effort to be more profitable.
- You (or your key advisors) possess the knowledge necessary to perform the activity as a successful business enterprise.
- You’ve previously been successful in performing similar activities profitably.
- Your activity was profitable during at least three of the last five tax years, including the current year.
- You can expect to earn future profits from the appreciation of assets used while performing the activity.
All of the facts and circumstances that pertain to your activity should be considered in making the hobby vs. business distinction. According to the IRS, no single factor should be decisive in the distinction.
Limits to Deductions for Hobbies
In general, it’s more beneficial from a tax standpoint if your activity is considered to be a business rather than a hobby. This is because there are special rules and limits with regard to the deductions you can claim for hobbies.
If your activity is deemed a hobby, you can usually deduct ordinary and necessary expenses associated with performing the activity, within certain limits. Deductible hobby expenses are listed on Schedule A (Form 1040) as an itemized deduction.
However, you can only deduct hobby expenses up to the amount of income generated by the activity. In other words, losses sustained while performing hobbies can’t be deducted from other income. Having a money-losing hobby could actually increase your taxes because you won’t be able to take any deductions to offset income generated by the hobby.
But if your activity is deemed a business, you can usually deduct losses sustained while conducting the business from other income. In addition, these losses can be carried forward or backward to previous or future tax years.
There are distinct differences between whether your side gig is a hobby or a business that can impact how you file your taxes, so you should be diligent in making sure that any revenue-generating activities you perform are classified correctly.
Be sure to speak with a tax professional for detailed guidance in your specific situation.
This blog is for informational purposes only and is intended to offer guidance; not specific legal or tax advice. Clients are advised to consult their CPA before taking action based on this advice.
Brian Wainscoat, CPA
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