Do you have a small business or a hobby?
A lot of small businesses start out as hobbies. After time and growth, the entrepreneur slowly starts devoting more time to the endeavor and it gradually grows into a full-fledged business. These are the success stories that motivate many people to strike out on their own.
Unfortunately, many “small businesses” never grow to this level and are considered a hobby for tax purposes. This isn’t necessarily a bad thing. In fact, many hobbies are successful in that they break-even or make a little extra money from time to time.
Just to be clear, the whole point of this post is to help illustrate the differences between a hobby and a small business and to explain some of the tax consequences of having your activity be treated as a hobby.
What is the difference between a hobby and a small business?
The primary distinction for tax purposes between a hobby and a small business is what has become known as the “Profit Motive.” This profit motive can be hard to determine and must be evaluated for each business activity, especially when there are losses involved with the activity.
The Internal Revenue Code Section 183 states there is a presumption of having a profit motive in the activity if you have net income for the activity for 3 or more of the taxable years in a period of 5 consecutive taxable years. This means, if you activity is able to generate a profit for 3 out of 5 years, you can most likely consider it a small business and report all your income and deductions on Schedule C, Profit or Loss from Business.
The US Treasury has also come out with regulations that have 9 factors that the IRS can use to determine whether a specific activity is a hobby. See Reg Section 1.183-2
Why does the distinction between a hobby and small business matter?
The tax rules around hobbies and small businesses are completely different. A small business reports all its profits and losses on Schedule C of the owner’s Form 1040, Individual Income Tax Return. If there is a loss, the individual is allowed to recognize this loss and use it to off-set other income on the return. If there is net income from this activity, the income is taxed as ordinary income and is also subject to self employment taxes.
However, for a hobby, the income and related expenses are reported differently. To start, the income is reported on page one of Form 1040 using line 21. This line is for “Other Income.” The full amount of income goes on this line, meaning it is not netted against any expenses of the activity. The expenses get reported on Schedule A, which is used for itemized deductions. These expenses are characterized as Miscellaneous Itemized Deductions and they are subject to the 2% of adjusted gross income limit. In addition to being treated as an itemized deduction subject to the 2% AGI limit, the amount of deductions can not exceed your hobby income. This means you can’t have a net loss on your tax return for your hobby.
Final thoughts and considerations on hobbies
There’s nothing wrong with having a hobby. In fact, many people receive a lot of enjoyment and personal fulfillment by participating in hobbies. The point of this post is to illustrate some of the differences between a hobby and a small business so you can know, ahead of time, how you’ll be taxed on the income from your activities. Particularly, if you determine that you’re participating in a hobby, don’t go spending a lot of money just because you think you can deduct it. There’s nothing worse than having to tell a client that all this money they spent is not deductible because their activity is a hobby.
There is an opportunity to plan for this and, if you really enjoy the activity, turn it into a small business by establishing proof that you’re trying to earn a profit. You do this by using the list above to figure out what you can add to your activities to create a verifiable profit motive.
This post is not intended to give tax advice. As you can see from the above list of factors, each activity is unique and has must be looked at individually. There is a ton of information out there to help learn more about this topic. In addition, any tax professional should be able to answer your questions about hobby losses and how to classify the activity.
For more information see these resources:
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