It’s a common question, when does my hobby become a business? It’s an important questions that has profound tax ramifications. Today I and going to try to answer that question, hobby or a business.
Asking the Question, Hobby or a Business
For those just tuning in, I recently wrote a series of 2 articles on Starting a Business. At the end of that the one thing Erik from The Mastermind Within pointed out I was missing the distinction between a hobby and a business. I ultimately decided this would make a better stand alone topic then something to be left to comments or a tag along to the existing articles.
Why Hobby Classification Matters
First let us explore why this matters from a tax perspective. In general, hobby expenses are not deductible from your other sources of income. They can be used to offset income from the hobby itself, if there is any. However it can only be used up to the extent the activity produces income in the first place. In either case, a hobby or a business, any deduction has to be reasonably relatable to the activity.
Let’s look at an example. Say you have a side hustle of painting in addition to your W-2 income. You sell a single painting for $100. It costs you $150 in materials, easel, and advertising to make and sell that painting. If painting is classified as a hobby for you then you report 0 income on your taxes for the painting sale and are done. If your painting was a classified as a business you could also offset your W-2 income by an additional deduction for the remaining $50 loss.
Benefits of Business Classification
Needless to say this can be very advantageous for businesses that might invest for the future where a loss in any given year may portend future profits. For example, in my painting example perhaps I was buying my easel up front. In future years I won’t need to buy an easel so my costs would reduce to $50 dollars leading to $100 profit on the same sales. In this hypothetical case under a business I’d still get tax relief from the first years loss. Under a hobby I’d only get credit if I could somehow split the easel cost over multiple years. So needless to say you want to be a business, especially in the beginning or investing years of a business.
Downside of Business Classification
If I spend a bit of time talking about the upside of business classification, I do need to mention the downside. The big one is insurance. Your personal insurance coverage only covers your actions, not the actions of any business you run. As such when you cross the line from hobby to business you will typically lose your existing insurance coverage. At that point additional costs come into play for business insurance.
Do you have a Hobby or a Business?
In General the IRS considers a few factors to make the decision whether you are a hobby or a business:
- Do you put in the time and effort commensurate with wanting to make a profit?
- Do you do things like have a business plan, budgeting, and separating expenses that businesses should do?
- Are losses outside your control or occurring during the beginning stages of the business?
- Do you depend on this income?
- Are you doing the activity largely for personal pleasure?
- Have you made a profit in this business in the past? Has this activity done so for others? Are you likely to make profits in the future?
- Do you have the information available to be successful at this business?
- Have you changed processes to improve profits?
None of these alone are enough to qualify you as a hobby or a business, but they all are weighed.
Common Theme, a Business is For Profit
Notice the common theme here, the IRS is only going to qualify you as a business if you are doing so for profit. They are trying to avoid people just using a hobby expense to reduce their taxes. It needs to be about the money rather than simply the enjoyment of the activity.
If you were audited the IRS will likely ask you all of the above questions to determine your profit taking orientation. That being said the government will likely not darken your door step for this reason should you show a track record of making profits. Particularly if you show profit during 3 of the last 5 tax years*, inclusive of this year, then you can claim your activity is done for the purpose of profit. As such you can classify yourself as a business as the IRS will then assume you are trying to be profitable.
My Personal Scenario
First off, my wife clearly runs a consulting business. There are no doubts there as profitability in consulting largely precludes losses, ie. there is not a lot of overhead. So I will not spend any more time on that business.
Is Full Time Finance a Hobby or A Business?
What about my blogging business? I have to split Full Time Finance up into time periods a bit here. Before we get started, a general picture of Full Time Finance’s expenditures are in order. The only expenses to date for Full Time Finance are the subscription server fees, business license, and the domain name. All three of these items are paid by the year.
Year 1: A Hobby
In year 1 we made next to nothing from the site. It certainly was not profitable and profitability was not in sight. I always ran the site with a business plan, proper record keeping, business license, and other things to meet the spirit of having a business. But there was no guarantee at that time I would keep it up long enough to see a return. As such in year 1, I treated Full Time Finance as a Hobby for tax purposes. Honestly, better safe then sorry over such a small deduction amount.
Year 2: Technically a Business and Some Profitability
In year 2, Full Time Finance began to see profitability, if only just. In 2017, I treated Full Time Finance as a business. It largely would not matter since it was a profitable endeavor so the tax treatment was the same, but I did make the shift since it would be justifiable in the eyes of the IRS.
This prepares the site should I eventually invest in greater financial growth in some way that triggers an unprofitable year. Establishing year 1 as our first profitable year and ensuring future profitability will occur before a potential investment year will decrease the likelihood that the IRS comes knocking on my door in future years.
A Side Hustle can Still Be Enjoyable and For Profit
Year 3 and the road ahead, I continue to expect mild profitability. I plan to continue to manage the site as a business. There is an aspect here that I only monetize the site enough to make a small profit, so in some ways this is a pleasure enterprise. If I expected any sort of significant or prolonged losses with Full Time Finance I would likely not be considering it a business just to avoid a gray area in the law. After all, most blogs are not businesses. However, so long as profitability continues to grow at a moderate pace and remains one of our goals I do not have a concern. It’s possible to enjoy your side hustle, so long as you are also doing it for the purpose of making some sort of profit.
Do you have an activity that is near the line between a hobby or a business? If so what is it?
*A note, there is an exception to the 3 in 5 years for those with race horses. In this case it is actually 2 of the last 7 tax years profitable. I assume none of my readers are racing horses, but I could be wrong so it is included here for completeness.
Full Time Finance is for Entertainment Purposes Only. If you have any question about your tax classification please consult a licensed attorney.