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How do you distinguish between a business and a hobby?

Friday, January 03, 2014

Planning appropriately and separating hobby activities from a business plan and business income

The gig economy has been in full swing for several years. Gigs such as freelance projects, delivery drivers, pet sitters, or short-term contracts for a business can supplement full time business earnings. In addition to gigs, there are other ways that people can enjoy their passions recreationally.

However, as more people work side hustles or create different types of businesses for extra income, it is crucial to recognize the difference between side business projects and hobbies that you do for fun. Working on a hobby project is not the same as being a business owner, and as such, there are important factors and considerations to take into account. Arguably, hobbies are good for keeping the body and mind fit and healthy, developing excellent problem solving skills, and building connections with others. Whether hiking, birdwatching, or participating in a sport, hobbies help people unwind from the stressors of life.

However, if you are engaged in a hobby activity that starts to earn consistent income, you will need to be mindful of at what point the hobby transitions into a small business or a general business entity. Also of note is that some businesses can transition back into hobbies based on income reporting, overall business success, and general business performance.

What is the difference between a hobby and a business?

Generally, hobbies are activities that are completed for recreation without the intention of making a continual profit. Hobbies can include crafting, gardening, running, or exploring the great outdoors, among others.

Businesses, on the other hand, are designed to make money; to be profitable. Profitable businesses typically go through a startup phase which involves establishing a bank account, organizing structures for employment taxes and federal income tax, and tracking various business expenses that can contribute to the financial bottom line. It is also common that startup businesses have startup costs or business losses at the beginning that can be deducted on business tax returns. As you can see, the tax implications immediately kick in when a hobby transitions to an entity that has a profit motive, like a business.

Let’s next look into how to determine if you have a business or a hobby.

How to tell if you have a business or a hobby

The Internal Revenue Service (IRS) has established definitions that outline what defines a hobby and what defines a business. For tax purposes, the IRS designates a business as one that has the primary purpose to make income with regularity and consistency. It is important for businesses to maintain detailed accounting records of cash flow, income, expenses, and other business transactions that legitimize business operations. Businesses are also allowed to deduct expenses.

A hobby is generally seen as a not-for-profit activity, and may or may not come with the designation of being a non-profit entity, such as a 501c3 organization. Those who engage in hobby activities are not allowed to deduct expenses.

When does my hobby become a business (and vice versa)?

Some activities that start as hobbies may expand and grow to become full-fledged businesses. In fact, many businesses that are launched begin because someone had a passion for a product, service, or cause, and started it out as a hobby because of that love and passion for what they were doing. For the IRS to designate your hobby as a business, you have to prove profit motive and ongoing business plans (and documentation) that supports your move to profitable activities.

On the flip side, if you establish a business and you continue to experience regular business losses for many years, the IRS may shift your business classification to be a hobby activity.

Tax rule considerations

Businesses that are designated as partnerships, limited liability companies, or as an entity with a sole proprietor are required to file taxes and report taxable income. Even for individual entities who maintain a hobby that consistently earns income, this information must be reported as well. If a person engages in their hobby activity and has losses, this is known as hobby loss. All of this information is required to be reported to the IRS. Because S corporation businesses file their taxes in conjunction with personal tax return information, hobby loss rules apply to S corporation owners, specifically reporting any loss of funds. However, it should be noted that lobby loss rules do not apply to other business entities.

IRS ranking factors

To help Americans determine whether the activity they are engaged in is a business or a hobby, the IRS has developed factors to consider. These factors also help individuals who generate income from their hobby and/or business to understand the classification of this income.

  • Do you keep accurate records? If you are running a business, then it is important to keep business and personal records separate. If you are enjoying a hobby, the documentation will rely less on taxpayer requirements and not need as much diligence with accounting and record books.
  • Do you intend for it to be profitable and does your time and effort reflect that? If there is intent for profit, then generally the activity should be categorized as a legitimate business.
  • Do you depend on the income from the activity to survive? Hobby activities are often generating income that does not have a significant impact on the day-to-day living of the participants. However, if income generated from your activity is part of the cashflow you need for living expenses, then you may need to consider classifying your activity as a business.
  • Do you alter your model to try to make your business more profitable? Again, when profit motive is present, there is reason to believe that your activity falls under a business structure.
  • Do you have enough knowledge on the subject to turn it into a business? Many enthusiasts start a hobby for fun and may or may not be subject matter experts on the hobby. However, if your knowledge base is expanded for the purpose of seeking more income, this may shift how your activity is categorized.
  • Are your losses a normal part of startup costs or are they due to circumstances you can’t control? Ongoing losses for a business may showcase the lack of function in the marketplace or the lack of successful implementation of the business plan. In this case, some established businesses can be re-designated as hobby activities.
  • Have you made a profit doing a similar activity in the past? If established profit has taken place, your tax situation may best fit under the business operation model.
  • Was this past profit consistent or did it see more activity in some years and less in others? Looking at consistency of income is helpful in determining the overall trajectory of the activity and if the activity can shift into a more structured business model.
  • Do you expect to make a profit from the activity in the future? This concept addresses the presence of profit motive and the intention to make more money over time in future business activities.

Can I still use tax deductions for my hobby?

In 2017, the Tax Cuts and Jobs Act shifted rules for what deductions are allowed for tax returns. Specifically, miscellaneous itemized deductions are no longer allowed to be deducted, including hobby-related activities. With this change, new tax implications took place for reporting hobby activities, especially limiting deductions that occur from this type of activity. Prior to the implementation of this law, you could take deductions of hobby expenses on Schedule A, but only if it was more than 2% of your adjusted gross income.

Legitimate business practices

Having a stronger understanding of the differences between hobbies and businesses, small business owners should be even more concerted to maintain high levels of business processes, activities, and procedures to continue to meet the standards of IRS designations. If businesses fail to comply with certain standards or showcase ongoing profit motive, then there could be significant tax implications or audits from the IRS.

Good business practices that meet IRS standards include setting up a separate business checking account, keeping diligent records, registering your business at the state level, and complying with all local, state, and federal tax laws. Additionally, promoting your company’s business and operations to customers is essential. Brand promotion can be completed through business social media profiles as well as participating in other business-related organizations and networking activities with other businesses in the industry.

Next steps

Are you ready to learn more about the difference between hobbies and businesses? Are you interested in gaining a better sense of how IRS designation can impact your tax situation?

Heartland is ready to help.

Heartland helps nearly 1,000,000 entrepreneurs make and move money, manage employees and engage customers with human-centered technology solutions that allow them to rise above the daily grind and lead their businesses into a brighter future. Learn more at heartland.us.