Much of the determination of whether you have a business or a hobby depends upon your intent. On tax returns, businesses have a profit motive. Since we all have a vested interest in assuring tax returns are not used improperly to subsidize someone's hobby, the IRS provides several questions to help determine whether an activity is being performed for profit, including:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from the activity?
- How enjoyable is the activity? An activity like jewelry making is more likely to be questioned than a trash pickup service.
- If there are losses, are they due to circumstances beyond your control? Did they occur in the start-up phase of the business (when businesses would expect to have a loss)?
- If your business has had a loss in prior years, have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
- Has the activity make a profit in some years? The IRS expects businesses to make money three out of five years. The IRS also looks askance at taking huge losses followed by three years of tiny profits.
Why does this matter?
The IRS requires you to report all income on your return. Business income is reported on a Schedule C. Reasonable expenses are allowed to be subtracted from that income. If the result is a profit, you will owe self-employment taxes and ordinary taxes on it. If the result is negative, it may be subtracted from your other income.
Hobby income is reported as 'Other Income' on line 21 of form 1040. All the income is reported there. Expenses associated with hobby income may only be claimed as a part of itemized deductions on Schedule A and are limited.
Each situation is different
Every person has a unique situation to be examined. But everyone can benefit from determining whether they have a hobby or a business before they file.
