Many people dream of turning their hobby into a business – and a few people are determined and lucky enough to realize this dream. But as your hobby evolves into a full-blown business, you may quickly become overwhelmed with the accounting, taxes, and compliance required to operate legally.
Whether you believe you’re operating a business or a hobby, the IRS may classify your business differently, meaning a different set of tax requirements must be followed. Non-compliance can result in stiff fines or penalties, which you may not be prepared to pay.
To be considered a business, you only have to qualify on several factors to adequately demonstrate to the IRS that your hobby is a business. The IRS looks at nine factors to distinguish a business from a hobby. These factors include:
- How you handle things. The more professionally you conduct yourself while engaging in your hobby/business, the more legitimate it will seem in the eyes of the IRS. Sending a text or simply asking someone for the set amount is far different from completing a detailed invoice.
- Your expertise. There is a distinction between hobby businesses just getting started and those with a long history of experience and expertise in the field or industry.
- Time and effort. You don’t necessarily need to work full-time to be classified as a business. However, it is generally sufficient to classify your hobby as a business if you can demonstrate that you make a reasonable effort for the profits.
- Having past professional successes is one way to show that you mean business. In addition, this history brings a degree of legitimacy to your current endeavors.
- Most new businesses need help with profitability, even those that start as hobbies. The IRS can look at profitability (or losses) to determine whether you are operating a business or engaging in a hobby.
- Relative profits and losses. In addition to overall profitability, the IRS can look at how profitable you are in relation to other businesses in the industry.
- Financial status. One way to determine whether you have a business or hobby is to consider how much you need the money earned from the activity. If you need the money to make ends meet, it’s more likely that they will consider your company a legitimate business. Whereas, if you don’t need the money and have high levels of disposable income, they may classify it as a hobby.
- How much did you enjoy the activity. To the IRS, there is a distinction between doing something that happens to bring you money and doing something because it makes money.
- The potential for your business assets to appreciate. This factor refers to the potential profit you could make if you sell your assets down the line. If there is an expectation that these assets will appreciate, it could help with the argument that your hobby is a business.
Wrongly considering your business to be a hobby could result in paying excess taxes. If you think you are operating as a hobby, but you actually qualify as a business, you could miss out on tax savings through multiple ways. Consulting accountants should be your first priority if your hobby meets some of these criteria.
- Hobby income remains taxable, while expenses are not considered. On your tax return, hobby earnings over $400 are reported under ‘Other Income,’ which makes the profits taxable. Unfortunately, you cannot claim any business expenses if it’s a hobby. This scenario results in paying more taxes than you should fairly owe.
- You cannot write off expenses. For example, you cannot write off anything that is purchased while engaging in hobby activities. Whereas, if you are classified as a business, you can write off everything you spend required for the activity, significantly reducing your tax burden.
Sometimes, it may be more beneficial to classify your hobby as a hobby. For example, business profits are taxed at an additional 15.3%, but hobby income isn’t taxed at that rate. This means that, in some cases, it may be beneficial to keep your hobby a hobby even without any write-offs.
As you can see, determining when your hobby becomes a business can be very difficult. And classifying it as one or the other can be beneficial, depending upon your unique circumstances. To learn more about the best option for your hobby business, contact the experts at Parker Business Consulting today!
Parker Business Consulting & Accounting, P.C. is a unique firm with more than a combined 75 years of experience in private industry, coupled with a strong background in public accounting. This combination enables us to provide valuable assistance based on direct experience with many of our clients’ same issues.