Does it matter for your taxes if you spend $500 on your hobby or if you spend the same amount promoting your sideline where you make extra money? For sure yes. If your activity is a hobby, your expenses are not tax deductible. But if you have a business (even a very small business), you can write off your expenses. That can cut your costs in half, leaving the IRS to pay the other half.
As you can guess, that makes the line between hobby and business one that the IRS watches carefully. Let’s say you lose $20,000 a year in the “business” of raising, training and caring for sighthounds. You can report the loss on Schedule C of your Form 1040 and write it off from your wages. Assuming your combined state and federal tax rate is 40%, raising sighthounds really only costs you $12,000.
If your greyhounds are a hobby, you cannot claim a loss. But before you decide to turn your non-deductible hobby into a deductible business, be careful. This is an area of intense scrutiny from the IRS. According to the IRS, the biggest difference between a hobby and a business is that businesses operate for profit, while hobbies are for pleasure or recreation.
Not everyone makes a profit right away, so the IRS says you’re supposed to be operating for a profit if you make a profit in 3 years out of 5. But you can still convince the IRS you’re running a business, even if you make a profit in just 1 year out of 10. Still, don’t expect it to be easy, and expect to have to take the IRS to court. Good records and operating in a business manner are very important.
Whether you’re pursuing a hobby or running a business, if you accept more than $600 worth of goods and services using online marketplaces or payment apps, you could receive a Form 1099-K. Proceeds from the sale of goods, including personal items and services, are taxable income that must be reported on tax returns.
There are a few other things that people should consider when deciding whether their project is a hobby or a business. No one thing is the deciding factor. Taxpayers should review all factors to make a good decision. These questions can help taxpayers decide if they have a hobby or a business:
- Do they conduct business in a professional manner and maintain complete and accurate books and records?
- Does the time and effort they put into the activity show that they intend to make a profit?
- Does the activity generate profit in some years? If so, how much profit does it generate?
- Can they expect to earn a future gain 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 your control or are they normal losses for the start-up phase of your type of business?
- Do they change their methods of operation to improve profitability?
- Do the taxpayer and their advisors have the necessary knowledge to carry out the activity as a successful business?
Here are some tips:
1. Matching of income and losses. The IRS is less likely to question whether you are involved in a business if your income from the activity exceeds your expenses.
2. Keep good records. It matters if you behave in a professional manner. Keeping good records and posing as the manager of a business will help.
3. Show a profit three years in five. If you make a profit three years out of five (or two years out of seven, if your business is horse breeding), the IRS show off you are in business to make a profit. That presumption is worth a lot since you probably won’t have to fight through the mud with the IRS for a more amorphous test of facts and circumstances.
4. Plan income and expenses. Our tax system is annual and so are the profit and loss determinations. You may have more control than you think when you receive income and especially when you incur expenses. That control can help you turn a profit three years out of five.
5. Delaying an earnings determination. You can choose to defer determining the reason for profit 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 have met the three-out-of-five-year earnings presumption. The idea of the pick is to give it time to rise and make a profit. But be careful, most advisors do not recommend this choice as it might point to the profit motive problem. Additionally, it has the effect of extending the IRS statute of limitations beyond the normal three years. The IRS can examine all of the years in question after the deferral period has passed.
Whether taxpayers have a hobby or run a business, Registry mantenance It is key when declaring taxes. Also see these IRS publications: