With the current tight job market and the uncertainty of our economy, many people have considered trying to transition a hobby into a business to obtain some extra cash or create a job for themselves. Before you make this decision you need to understand a few rules, because there is a clear distinction between a hobby and a business in the eyes of the IRS. The primary distinction is whether you engaged in the activity with a motive for profit. The IRS considers a hobby as a not-for-profit activity; a recreational pursuit and does not consider the primary goal to be make profit.
In general, a business may deduct ordinary and necessary expenses for conducting a trade or business. An ordinary expense is an expense that is common and accepted in the trade or business. A necessary expense is one that is appropriate for the business. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit.
The following factors are some of the factors that the IRS may consider when it determines if an activity is a business or really a hobby:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Does the taxpayer depend on income from the activity?
- If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
- Has the taxpayer changed methods of operation to improve profitability?
- Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
- Has the taxpayer made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
If an activity is not for profit (a Hobby), losses from that activity may not be used to offset other income. An activity produces a loss when related expenses exceed income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations. Deductions for hobby activities are claimed as itemized deductions on Schedule A (Form 1040). These deductions must be taken in the following order and only to the extent stated in each of three categories:
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Deductions that a taxpayer may take for personal as well as business activities, such as home mortgage interest and taxes, may be taken in full.
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Deductions that don’t result in an adjustment to basis, such as advertising, insurance premiums and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
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Business deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.
Additional information can be found in IRS Publication 535, Business Expenses. Of course, it’s always best to discuss your unique situation with your accountant.
