Is It a Hobby or a Business?

An age old question for those looking to make a living (or even just a side hustle) out of their passion: is this a hobby or is it a business? It’s a tough one to answer, and it has a lot of nuances. But especially for early entrepreneurs, it is an important quandary to confront.

First, how are the two different when it comes to taxes? It essentially comes down to are you making a profit and is that profit reasonable for the amount of expenses going into the endeavor. If you’re spending $40,000 every year for several years on your passion of choice and making only $100 in profit, that doesn’t seem like business, does it? Better sort it under hobby.

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When it comes to more of the nitty gritty of the financials between the two, the biggest difference is what can be deducted from your personal tax statement. Both small businesses and hobbies are reported on your yearly tax filing. But for a hobby, you can’t carry forward losses; any expense can offset only a business income. If it is truly a business, those losses can offset other ordinary incomes you earn and be carried forward year over year indefinitely to offset income in the future. This is how Amazon was able to pay $0 in taxes despite making millions a few years ago. 

Photo by Bozhin Karaivanov on Unsplash

You are a business if your expenses related to a trade, a craft, or an income-producing activity are engaged in for profit. To determine if an activity is engaged in for profit, consider factors such as the following, which come directly from the IRS:

• The time and effort invested in the activity indicating a profit motive

• Dependency on income from the activity

• Losses due to uncontrollable circumstances or during startup

• Changes made to improve profitability

• Knowledge to run the activity successfully

• History of profits in similar activities

• Occasional profits from the activity

• Expectation of profit from asset appreciation

You can assume an activity is presumed to be for profit if it generates profit in at least three of the last five tax years. So, if you don’t want a knock on your door from the IRS, you need at least three out of five years to be profitable in your business venture. Starting out, you are 100% allowed to take a loss the first year. If you have to buy a piano or lease an office space in order to expand, you might not have a profit.  

Losses from activities not engaged in for profit (hobby) cannot be used to offset other income, which is the key difference between a hobby and a for-profit business. 

Deductions are limited to the amount of gross receipts from the hobby and must be itemized on Schedule A of Form 1040. 

As I tell family and close friends, “If you think you are being smarter than the IRS, you are probably in danger of being audited.” With tax planning, we can help to mitigate any issues that arise from this distinction and ensure that any losses are offsetting the maximum amount of income so you can pay the lowest bill possible.