9 Factors the IRS Uses to Determine If Your Business Is a Hobby for Tax Purposes
Most people assume that all businesses are treated equally in terms of income, expenses, and deductions—but that is not the case. While most businesses are started with the goal of making a profit, there are some that are simply extensions of the business owner’s personal interests: think of people who have made a name for themselves with their photography skills, or cake baking and decorating.
If you have decided to monetize your passion project, you need to know about the distinctions the IRS looks to in determining which businesses are for profit and which are hobbies, as well as the changes that have recently been made in how each of the two is taxed.
In assessing whether a business is a hobby or not, there are nine separate factors that the IRS uses. Each is taken into consideration, with no single one outweighing the others. They are:
- How is business conducted? Are income and expense records maintained accurately? Does the business have an established business plan, complete with goals, expectations, and how the business owner intends to achieve what is described within that plan?
- Does the business owner spend a significant amount of time on the business? Is that time largely recreational or is it substantive? The IRS will not count the fact of a business owner having a separate full-time job against the possibility that their business is established for profit, especially if they dedicate a substantial amount of time to it on a regular basis or have hired another well-qualified individual to assist with the business’ operations.
- Can the business owner afford to have the business shut down without a significant impact to their ability to support themselves?
- How much control does the business owner have over the losses that they incur? It is one thing to have losses that are based on the costs of starting a business, or on acts of God or other scenarios that are out of their control: it is entirely different if the business is being conducted as a secondary and speculative source of income that is not receiving the kind of attention that a full-time, for profit business would.
- If the business has not been successful, have attempts been made to change the process in order to improve revenues or profitability? Have these changes in process been documented?
- To what extent is the business owner an expert in the industry? Have they pursued an education on best practices prior to starting out, or was their entry into the field undertaken casually and with little research or background?
- Has the business owner run a similar business in the past, and if so, has it been successful? Evidence of previous profitability works towards supporting the identification of a business as having been established for profit.
- Whether the business has consistently lost money or not, is there any hope of profitability? If so, what is that hope based upon?
- Does the business hold assets that may appreciate in value? Even if the business’ revenues are lacking, the chance for earning a profit through asset appreciation and the sale of those assets in the future work to a business owner’s favor in having their business identified as more than a hobby. However, this is only supported where there is documentation of other efforts towards profitability.
Beyond these nine factors, the IRS will also weigh the profitability that a business shows over a period of years. If in three or more out of any five consecutive years a profit is shown, then a profit motive is presumed. If the business involves training, showing, racing or breeding horses, that assessment only requires two profitable years out of a consecutive seven-year period.
For profit businesses are taxed on their profits and are able to deduct their losses. They use a Schedule C to report both expenses and income and to determine whether they have earned a profit or loss by deducting their expenses from their income. That number is entered on their tax return. (There are some circumstances where business owners forego deducting losses, but this only applies to business activities that are considered “passive,” and that would not apply to the type of business in which a determination of whether it is a hobby is the topic).
Businesses that are hobbies are not permitted to deduct their expenses, though they do need to report any income that they earn. This is a relatively new development: prior to the passage of the Tax Cuts and Jobs Act of 2017, businesses that were hobbies were permitted to list expenses on Schedule A up to the amount of their business’ income and deduct them. This ability stopped with the passage of the tax act and is not scheduled to be reinstated until 2025. Income from a hobby business gets reported on Schedule 1 of the 1040, with no deductibles allowed for expenses.
Entrepreneurs who are not certain as to whether their business will be eligible to be seen as a for-profit business should speak with a professional advisor to determine how to best support their long-term goals.
Sonu Shukla, CPA writes for CountingWorks, an accounting news and advice website. Reach his office at [email protected].
About Sonu Shukla, CPA, CFP
Sonu Shukla is a Certified Public Accountant as well as Certified Financial Planner. He believes in proactive tax planning and has the skills, education and experience to demonstrate passionately planned financial strategies.
His firm tailors highly efficient tax plans for his small business clients, all in a one on one environment where he and the client can bounce ideas around until every detail is worked out. Located in Orlando, FL, he services all of Florida.
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