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Hobby versus business - Key differences you need to know for taxes

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Updated on:
December 12, 2022
December 12, 2022
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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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At What Point Is a Hobby Considered a Business?

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:

  • Function primarily with the purpose of making a profit and generating income from the activity
  • Engage with regularity and continuity, generating steady income throughout the year.

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:

  • Do you carry your hobby activity in a way that is considered a businesslike manner? Do you keep records of your activity?
  • Does the time and effort that you put into your hobby suggest that you intend to make a profit from it?
  • Are the losses that you experienced due to circumstances that were beyond your control? Or are they what you would consider "normal" in a startup?
  • Do you depend on the income coming from your activity in order to maintain your livelihood?
  • Do you continuously try to improve your methods so that you can make more profit from your activity?
  • Do you have the knowledge necessary to transform said activity into a successful business?
  • Can you expect to make a profit somewhere in the future due to the appreciation of your assets?
  • Did you make a high amount of profit in the past 3-5 years from your activity?
  • Did you try any other similar activities in the past that ended up successful?

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.

How Much Money Can You Make Through a Hobby Before You Start Paying Taxes?

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.

Do I Need to Report My Hobby As a Business?

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.

How Does the IRS Define a Hobby?

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.

Can I Get Tax Deductions for a Hobby?

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.

How to Switch from Hobby to 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.

Keep Accurate Records

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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Make a Business Plan

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.

Get the Licenses

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.

Keep Separate Business Accounts

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.

Frequently Review Business Performance

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.

The Bottom Line

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.

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