Running a business on the side can give you valuable tax deductions as well as additional income. However, the Internal Revenue Service (IRS) decides whether the business is actually a hobby or not. If the IRS says so, you could lose the ability to deduct the expenses from your income. The main rule for determining whether an activity is a business or a hobby is whether it has produced a profit for at least three out of five years. Other considerations may come into play. However, this is not definitive. We’ll discuss how turning your hobby into a business can affect your taxes and what the IRS is looking for.
Speak to a financial advisor to help you manage your tax liability.
How turning a hobby into a business affects your taxes
If you can find an activity that you enjoy that also generates profit, you can have fun while earning money. And as an added benefit, you can get deductions to reduce your taxable income. Examples of businesses that are potentially enjoyable as hobbies might include musical performances, creating crafts to sell, and nature hiking trips. If you charge money to play music, sell your crafts, or provide guiding services, the income could make a business out of what would otherwise be a hobby.
At tax time, hobbies and businesses are treated very differently. Money you pay to engage in a business, such as buying a sound system for musical performances or mileage to travel to craft fairs, can be subtracted from sales income to reduce taxable income . If the business produces a loss, you can even deduct this loss from other income. This includes salary from employment, which reduces your overall tax bill.
However, making a business out of a hobby doesn’t have to mean good times. For one thing, if the IRS suspects you of trying to claim business losses for something that’s really a hobby, you could be audited. An IRS audit isn’t likely, but it’s not fun either.
You are more likely to simply lose the ability to deduct losses if your business is considered a hobby. It could increase your tax bill and take away one of the nice perks of having a business that’s as enjoyable as a hobby.
IRS Guidelines for Business Identification
The IRS uses guidelines to determine whether an activity is a business or a hobby. But these are not carved in stone. An activity does not have to meet all of the guidelines to be considered a business. And, even though it seems to fall within business guidelines, it could still be classed as a hobby. Here are the guidelines and some details on their application:
- Safe port. The surest way to ensure that your activity is considered a business is to declare a profit. However, you are not required to make a profit every year. If your activity displays black ink for at least three out of five years, it is presumed to be a business. Again, this isn’t foolproof, but in most cases it will suffice. Even if you are not often profitable, your activity can still pass for a business if it meets one or more of the following guidelines:
- Profit motive. A hobby is for fun and recreation while a business is for making money. You may be able to convince the IRS that you’re doing something for profit even though you’re not actually making any money if you:
- Having earned money in the past through similar activities.
- Acquire assets, such as land, that have the potential for price appreciation.
- Run the business in the same way as similar businesses.
- Advertise or market to attract customers.
- Strive to acquire vendors and vendors.
- Work at the business full time or put in at least a significant amount of effort.
- Hire qualified employees to help you.
- Keep books and records to help you run the business.
- Depend on income from the activity to pay living expenses.
- Report normal losses that are no different from similar businesses or are due to uncontrollable circumstances such as fires, natural disasters or economic downturns.
IRS Guidelines for Identifying Hobbies
If your activity has certain other characteristics, it increases the chances that the IRS will consider it a hobby. This is even though it might otherwise be considered a business. Here are some of those considerations:
- Recreational aspects. If your activity is generally considered fun, like visiting seaside resorts or trying new restaurants, it’s more likely to qualify as a hobby than if it’s something decidedly not fun, like, for example. example, preparing tax returns or emptying a septic tank. reservoirs.
- Personal reasons. If the IRS thinks you are doing the activity because you like it or find it relaxing, it will more likely be considered a hobby.
- Other sources of income. If other activities, such as working or investing, provide you with enough income to pay your bills, the IRS is less likely to consider your activity a business.
Declaration of hobby and business income
You will generally report income from a business, whether it is operated as a side business or your primary source of income, on Schedule C of your Form 1040. Schedule C contains places for you to record a large variety of expenses. So you can accurately report your business income.
Income from a hobby that you do not expect to pursue profitably should also be declared. But it’s much less involved. You will do this on line 8j of appendix 1 of your usual 1040.
Turning hobbies into businesses is a dream for many people. Being able to enjoy what you do and earn money is the dream that many want to have. It’s even better when it can be deducted to reduce your taxable income. But you need to make sure your hobby is actually a business. If the IRS finds that you’re using your hobby as a business when you’re not, you could be audited. And to prove it’s a business, you need to make a profit in 3 of the last five consecutive years.
Tips for filing your taxes
- A financial advisor can help you during tax time. SmartAsset’s free tool connects you with up to three licensed financial advisors who serve your area, and you can interview your matching advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
- If you’re not sure if you’re better off with the standard deduction versus the itemized deduction, you might want to read up on it and do some math. Getting the facts before the tax filing deadline could help you save a significant amount of money.
- SmartAsset has free resources to help you during tax season. Check out our income tax calculator today and get started!
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