Tax Tip of the Week | Do You Have a Hobby or a Business?

You may not think Uncle Sam really cares whether your side hustle or even your full-time hustle is a hobby or a business.  Honestly, doesn’t Uncle Sam have more important things to worry about, such as the ERC mills cranking out millions and millions of fraudulently claimed funds.  Is the IRS really worried about my child’s show horses or my little farm for which I have a BIG tractor and a BIG barn but not much income.  But, yes – IRS agents lose sleep over whether you are improperly deducting pleasurable activities.  Hmm…is that the big difference between a hobby loss and a business loss?  If you are having fun losing money it must be a hobby and if you not having fun losing your hard-earned dollars your hustle must be a business.  Of course, we are chatting about losses here and whether they are tax deductible.  If you have a net profit in either a business OR a hobby – both are taxable income.  Obviously, the distinction between hobbies versus businesses is much more complicated than I will write here.  Mr. Wood explains in greater breadth and depth below. 

-Mark Bradstreet

Does it matter for your taxes if you spend $500 on your hobby, or if you spend the same amount promoting your side hustle where you earn extra money? It sure does. If your activity is a hobby, your expenses are not tax deductible. But if you are running a business (even a very small business), you can write off your expenses. That may cut your costs in half, letting the IRS pay for the other half.

As you can guess, that makes the line between hobby and business one the IRS watches carefully. Say you lose $20,000 a year in the "business" of breeding, training and caring for whippets. You can report the loss on Schedule C to your Form 1040 and write if off against your salary. Assuming that your combined state and federal tax rate is 40%, your whippet breeding really only costs you $12,000.

If your whippets are a hobby, you can't claim a loss. But before you decide to turn your nondeductible hobby into a deductible business, be careful. This is an area of intense IRS scrutiny. According to the IRS, the biggest difference between hobby and business is that businesses operate to make a profit, while hobbies are for pleasure or recreation.

Not everyone makes a profit right away, so the IRS says you are presumed to be operating for profit if you make a profit in 3 years out of 5. But you may still be able to convince the IRS that you are running a business, even if you have a profit in only 1 year out of 10. Still, don’t expect that to be easy, and expect to have to take the IRS to court. Good records, and operating in a business-like way are very important.

Whether someone is having fun with a hobby or running a business, if they accept more than $600 for goods and services using online marketplaces or payment apps, they could receive a Form 1099-K. Profits from the sale of goods, including personal items, and services is taxable income that must be reported on tax returns.

There are a few other things people should consider when deciding whether their project is a hobby or business. No single thing is the deciding factor. Taxpayers should review all of the factors to make a good decision. These questions can help taxpayers decide whether they have a hobby or business:
“Operating” in a businesslike manner and keep complete and accurate books and records?

  • Does the time and effort they put into the activity show they intend to make a profit?
  • Does the activity make a profit in some years – if so, how much profit does it make?
  • Can they expect to make a future profit from the appreciation of the assets used in the activity?
  • Do they depend on income from the activity for their livelihood?
  • Are any losses due to circumstances beyond their control or are the losses normal for the startup phase of their type of business?
  • Do they change their methods of operation to improve profitability?
  • Do the taxpayer and their advisors have the knowledge needed to carry out the activity as a successful business?

Here are some tips:

1. Match income and loss. The IRS is less likely to question whether you're engaged in a business if your income from the activity exceeds your expenses.

2. Keep good records. It matters whether you conduct yourself in a businesslike manner. If you keep good records and hold yourself out as running a business, it will help.

3. Show a profit three years in five. If you can manage to eke out a profit three years out of every five (or two years out of seven, if your activity is horse breeding), the IRS will presume you're in business to make a profit. That presumption is worth a lot since you probably won't have to mud wrestle with the IRS over a more amorphous facts and circumstances test. 

4. Plan income and expenses. Our tax system is annual and so are profit-and-loss determinations. You may have more control than you think over when you receive income and especially when you incur expenses. That control can help you make a profit three years out of five.

5. Delay a profits determination. You can elect to defer the determination of profit motive until the fourth year of your "business," or your sixth year in the case of an activity involving horses. To make this election you file a Form 5213, postponing the determination of whether you've met the three-out-of-five-years profit presumption. The idea of the election is to give you time to ramp up and achieve a profit. But be careful, most advisers don't recommend this election since it could flag the profit-motive issue. Plus, it has the effect of extending the IRS statute of limitations beyond the normal three years. The IRS can examine all the years in question after the deferral period has passed.

Whether taxpayers have a hobby or run a business, good record keeping is key when it’s time to file taxes.
Credit goes to Robert W. Wood. Published May 8, 2023 in the Wall Street Journal.

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.
This Week’s Author, Mark Bradstreet

-until next week

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