We all have that one activity we love to do. It is something used to take our minds off the stress of the day; it is our escape. However, there comes a time when this activity becomes more than a hobby, and under US tax laws and regulations is considered a business. But, how can you tell if what you’re doing is no longer a hobby, but a business instead?
As defined by the Internal Revenue Services, IRS, a hobby is an activity not executed with the hopes of making a profit. To determine the status of your activity, taxpayers are advised to follow appropriate guidelines to avoid misfiling an activity considered a business as a hobby and vice versa. The IRS affirmed that there is almost $30 billion per year in unpaid taxes due to incorrect deductions when a business is deducted or exempted from taxes because they were claimed as hobbies.
So, is it a business or just a hobby?
A business is any activity done with the intention of making a profit. While taxpayers may deduct necessary expenses for day-to-day business operation; this expense must be accepted and common in the business or trade. To determine what an appropriate expense is and to differentiate between a business and a hobby, you should take the following into consideration:
● Is your income based solely on the activity or is it a source of income?
● Is the activity done with the intention of making a profit?
● Did you change your method of operation to increase profitability?
● Did similar activity yield a profit in the past?
● Have you ever made money from the activity, even if you did not make any money this tax period?
● Is it possible for you to make a profit from the appreciation of assets used to execute dthis activity in the future?
● Do you or your advisor have the required knowledge for conducting the activity successfully?
● Were there any loses and if so, did it happen in the startup phase of the business or because of circumstances beyond your control.
What the IRS considers as profit where businesses are concerned
If your hobby/business made a profit at least three out of five consecutive years, two out of seven for activities such as showing, breeding and horse training, including the current tax year, then the profit must be reported.
Income tax as it relates to businesses and or hobbies requires knowledge and understanding of the IRS and how it operates. For example, if the activity was not conducted in the attempt to make a profit or in other words, it was not-for-profit, you cannot use losses (instances where your expense exceeds your income) from the activity to offset other income. The limit placed on not-for-profit losses applies to estates, S Corporations, individuals, trusts and partnerships.
Claiming Itemized Deductions on Schedule A (Form 1040) for Hobby Activities
If you have been over your taxes and went through your activities and is certain that it’s classified as a hobby rather than a business, you must follow the order below to the extent stated to file for each deduction:
● Deductions can be made for personal and business activities as well. For example, home mortgage taxes and interests may be taken in full.
● If the deductions being claimed does not lead to an adjustment in basis. Wages, advertising and insurance premiums may follow, in the event that your gross income exceeds the deductions stated in the first category.
● In the event that business deductions lead to the basis of property being reduced (amortization and depreciation), these deductions are taken last, but only if your gross income is more than the deductions taken in the above categories.
Is it a business or a hobby?
The sole difference between a business and a hobby is whether or not you are making a profit from the activity, how much you are making and how long you have been making it. If you were ever on the bad side of Uncle Sam, you already know that the IRS is not an institution you want to have in your business doing an audit. Therefore, it is essential that you report all income and examine your activities to determine if they’re just hobbies or businesses.
Properly documented records are the most efficient way to prove that you are operating a legitimate business. Saving your expense receipts is also another way to prove you have a business rather than a hobby. You can also prove that your activity is a business rather than a hobby by making a documented business plan. Business plans act as a prerequisite, indicating your intention of making a profit from your activities.
Joseph J. Gormley CPA