What’s in a word? A world of tax consequences when the word is “business” or “hobby.”
In a nutshell: If you and the IRS determine that an activity is a business, you’ll owe taxes on profits and will be allowed to deduct expenses for conducting that business. But if your passion for, say, making quilts is a “hobby,” you cannot deduct the fabric, thread, needles and labor needed to make the bedclothes.
Is your time-sapper really a business? Consider these criteria, and don’t try to blur the business-hobby lines, which could red-flag your return and trigger an audit.
- Do the time and effort put into the activity indicate an intention to make a profit?
- Does the taxpayer depend on income from the activity?
- If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the startup phase of the business?
- Has the taxpayer changed methods of operation to improve profitability?
- Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
- Has the taxpayer made a profit from similar activities in the past?
- Does the activity make a profit in some years?
- Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
The IRS presumes that an activity is pursued for profit if it made money in at least three of the past five tax years (including the current year). If your activity consists primarily of training, breeding, showing or racing horses, it’s considered a business if you posted profits in at least two of the past seven years.
Even with the above guidelines, the line between a hobby and a business isn’t always clear. The IRS may look at certain factors, such as, but not limited to, the following:
- Whether you carry on the activity in a businesslike manner.
- Whether the time and effort you put into the activity indicate you intend to make it profitable.
- Whether you depend on income from the activity for your livelihood.
Of course, an activity can be a hobby and still produce income, and you can deduct hobby expenses to a certain extent. If your activity is a hobby, however, you cannot use losses to offset other income.
The differences between a hobby and a business can be subtle, so be sure to give us a call before drawing conclusions about whether your particular activity is a hobby or a business.