Hobby versus business - exactly where do you fit right now? We live in a time when pretty much everyone can make a little side money, adding some extra income to their usual 9-to-5. And what better way to do that than to use a hobby you've loved your entire life?
Whether it's painting or some custom-made jewelry, hobby income can help you make it from day to day. But from which point should a hobby be considered a business? When will you start owing taxable income? This article will make it easier for you to understand if you need to pay 1099 taxes for your hobby.
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There aren't any concrete rules to determine when a hobby can be considered a business. Technically speaking, the IRS has a couple of rules that may suggest the activity you are dealing with is actually a business. According to the IRS, a business will do the following actions:
As long as you made a profit, you may consider that your hobby is, in a fact, a business. If you are only doing it as a pleasure and not for profit, then it remains a hobby.
For instance, let's say that your painting hobby expenses reach around $1000 per year. If you earn only $1000 per year as well while selling those paintings, it won't be seen as making a profit. In that case, it is a clear-cut hobby.
However, if you spend $1000 per year on expenses but earn $2000 for your pieces, then that will be seen as making a profit. At that point, your activity will be deemed a business.
To make matters easier to understand, here are the things that the IRS considers when making the difference between a hobby and a business:
If the IRS determines that your activity goes beyond the borders of "I'm doing this for pleasure," then it may no longer be seen as a hobby. If it borders on "I'm seriously planning to make money from this," then you will have a business and will be eligible for tax.
Technically speaking, the moment you start making money from your activity, you need to declare it and then pay your taxes. Even if you only earned a couple of dollars from that exchange, you will still need to declare it. No taxpaying yet; just declaring. It depends on your income whether you pay the tax or not.
The good news is that if your activity is truly a hobby and you are making no money from it, then you won't have to pay tax for it. Only if the IRS categorized you as a business that makes a profit will you have to pay taxes. At that point, you'll be able to get tax deductions for your business expenses.
Whether you have a hobby or a business, you need to report it just the way it is. A business cannot be reported as a hobby, just as a hobby should not be reported as a business. The only exception is if your hobby is actually making a profit.
For instance, if you are only getting some random income now and again, but do not make any actual profit, then there is no need to report it as a business.
If you don't see growing regular profit after deducting your hobby expenses, you can report it as a hobby. This can be done during the filing of your personal tax return, using form 1040. On line 8 of Schedule 1, put your information under "Other Income."
That being said, if your hobby suddenly starts making some money, then you'll need to report it as a business. The IRS may give you the slip for that if you just occasionally make some extra money from it - for which you'll obviously have to pay taxes.
Also, if you start being serious about making a profit from your hobby, and the money flow you get is gradually becoming steady, then you'll need to report it as a business. As long as you rely on it to be your source of income, you can't really pass it off as a hobby anymore.
The IRS defines a hobby as any activity that a person undergoes for pleasure, without the intention of making a profit. Income from hobbies still needs to be reported to the IRS, but the difference is that this income will not be taxable.
The IRS will look at the profit that you've made over the last 3-5 years. If they see that you clearly make a profit from the business and the profit has only grown over the past years, then the hobby will be re-classified as a business.
Some hobbies may not require you to make any expenses. Other hobbies can be pretty expensive. For example, let's say that you like to paint; surely, buying all those canvases, brushes and paint cannot be cheap. So can you deduct them when you get your tax return?
The answer is yes and no. If the expense was listed as a hobby for which you made no actual profit, then you are not eligible for itemized deductions. The Tax Cuts and Job Act of 2017 specifies that you cannot take any losses as long as it is reported as a hobby.
However, if the tax deductions are more than 2% of your adjusted gross income, then you might be eligible for them. Bear in mind that the amount you claim for these expenses cannot go over the total income you get from your hobby. It may also mean that if you begin to take itemized deductions, you might have to consider classifying as a business.
If you have decided that you want to make a profit and turn your leisure activity into a small business, you need to take the appropriate steps.
Otherwise, the IRS might challenge your tax claim, not truly recognizing it as a business. As a result, you may not be able to get your deductions - ergo, you won't be able to make a profit either.
Here's what you'll have to do in order for the IRS to see you as a business.
For your activity to be recognized as a business, you need to keep accurate records. Keep track of your records, log the transactions, keep track of expenses used in the activity, and send your formal invoices. This should help you at the end of the tax year.
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Every small business needs a business plan. It will show the IRS that you are actually serious about your business. If you made a profit in accordance with the business plan, then your hobby can be categorized as a business eligible for tax.
If you want to be taken seriously, then you need to get your license. It will tell the IRS that you are planning to conduct a business, not just a hobby - and will, therefore, make you eligible for tax return.
If you want to boost your business credibility, you might want to stop using your personal account for business transactions. Create separate credit cards and bank accounts. It will also make it easier for you to file your tax returns to the IRS.
For an activity to be categorized as a business, it needs to show a steady profit. Otherwise, if you make no profit, the IRS may keep you running as a hobby. While you run that way, you won't be able to get a tax return.
Tax is handled differently, depending on whether you figure as a business owner or a hobbyist. If you want to get tax return and make a profit, then you'll have to declare your activity as a business.
If you don't want to make a profit and just do it for pleasure - only selling to get your hobby expenses back - then you can declare it as a hobby. Each option will open different tax routes that you will have to respect.
A verbal contract (formally called an oral contract) refers to an agreement between two parties that's made —you guessed it— verbally.
Formal contracts, like those between an employee and an employer, are typically written down. However, some professional transactions take place based on verbally agreed terms.
Freelancers are a good example of this. Often, freelancers will take on projects having agreed on the terms and payment via the phone, or an email. Unfortunately, sometimes clients don't pull through on their agreements, and hardworking freelancers can find themselves out of pocket and wondering whether a legal battle is worth all the hassle.
The main differences between written and oral contracts are that the former is signed and documented, whereas the latter is solely attributed to verbal communication.
Verbal contracts are a bit of a gray area for most people unfamiliar with contract law —which is most of us, right?— due to the fact that there's no physical evidence to support the claims made by the implemented parties.
For any contract (written or verbal) to be binding, there are four major elements which need to be in place. The crucial elements of a contract are as follows:
Therefore, an oral agreement has legal validity if all of these elements are present. However, verbal contracts can be difficult to enforce in a court of law. In the next section, we take a look at how oral agreements hold up in court.
Most business professionals are wary of entering into contracts orally because they can difficult to enforce in the face of the law.
If an oral contract is brought in front of a court of law, there is increased risk of one party (or both!) lying about the initial terms of the agreement. This is problematic for the court, as there's no unbiased way to conclude the case; often, this will result in the case being disregarded. Moreover, it can be difficult to outline contract defects if it's not in writing.
That being said, there are plenty of situations where enforceable contracts do not need to be written or spoken, they're simply implied. For instance, when you buy milk from a store, you give something in exchange for something else and enter into an implied contract, in this case - money is exchanged for goods.
There are some types of contracts which must be in writing.
The Statute of Frauds is a legal statute which states that certain kinds of contracts must be executed in writing and signed by the parties involved. The Statute of Frauds has been adopted in almost all U.S states, and requires a written contract for the following purposes:
Typically, a court of law won't enforce an oral agreement in any of these circumstances under the statute. Instead, a written document is required to make the contract enforceable.
Contract law is generally doesn't favor contracts agreed upon verbally. A verbal agreement is difficult to prove, and can be used by those intent on committing fraud. For that reason, it's always best to put any agreements in writing and ensure all parties have fully understood and consented to signing.
Verbal agreements can be proven with actions in the absence of physical documentation. Any oral promise to provide the sale of goods or perform a service that you agreed to counts as a valid contract. So, when facing a court of law, what evidence can you provide to enforce a verbal agreement?
Unfortunately, without solid proof, it may be difficult to convince a court of the legality of an oral contract. Without witnesses to testify to the oral agreement taking place or other forms of evidence, oral contracts won't stand up in court. Instead, it becomes a matter of "he-said-she-said" - which legal professionals definitely don't have time for!
If you were to enter into a verbal contract, it's recommended to follow up with an email or a letter confirming the offer, the terms of the agreement , and payment conditions. The more you can document the elements of a contract, the better your chances of legally enforcing a oral contract.
Another option is to make a recording of the conversation where the agreement is verbalized. This can be used to support your claims in the absence of a written agreement. However, it's always best to gain the permission of the other involved parties before hitting record.
Fundamentally, most verbal agreements are legally valid as long as they meet all the requirements for a contract. However, if you were to go to court over one party not fulfilling the terms of the contract, proving that the interaction took place can be extremely taxing.
So, ultimately, the question is: written or verbal agreements?
Any good lawyer, contract law firm, or legal professional would advise you to make sure you formalize any professional agreement with a written agreement. Written contracts provide a secure testament to the conditions that were agreed and signed by the two parties involved. If it comes to it, a physical contract is much easier to eviden in legal circumstances.
Freelancers, in particular, should be aware of the extra security that digital contracts may provide. Many people choose to stick to executing contracts verbally because they're not sure how to write a contract, or they think writing out the contract terms is too complicated or requires expensive legal advice. However, this is no longer the case.
Today, we have a world of resources available at our fingertips. The internet is a treasure trove of invaluable information, platforms, and software that simplifies our lives. Creating, signing, and sending contracts has never been easier. What's more, you don't have to rely on a hiring a lawyer to explain all that legal jargon anymore.
There are plenty of tools available online for freelancers to use for guidance when drafting digital contracts. Tools like Bonsai provide a range of customizable, vetted contract templates for all kinds of freelance professionals. No matter what industry you're operating in, Bonsai has a professional template to offer.
A written contract makes the agreement much easier to prove the terms of the agreement in case something were to go awry. The two parties involved can rest assured that they're legal rights are protected, and the terms of the contract are sufficiently documented. Plus, it provides both parties with peace of mind to focus on the tasks at hand.
Bonsai's product suite for freelancers allows users to make contracts from scratch, or using professional templates, and sign them using an online signature maker.
With Bonsai, you can streamline and automate all of the boring back-office tasks that come with being a freelancer. From creating proposals that clients can't say no to, to sealing the deal with a professional contract - Bonsai will revolutionize the way you do business as a freelancer.
Why not secure your business today and sign up for a free trial?