Is your operation a hobby or a business? It matters when it comes to tax time. The key issue is whether what the IRS considers your operation to be. It impacts what you can deduct on your tax return.
What is better, being a business or a hobby?
If your operation is making money, regardless of being a business or a hobby, then you need to declare all your income. However, the amount of activity expenses you can deduct depends significantly on whether it is a business or hobby.
If your activity is a business, you can deduct all of your business expenses, subject to normal deduction rules. If your activity is a hobby, you can only deduct hobby expenses to the amount of income you obtained from that hobby. Only limited expenses can be deducted. What this means is that you can’t have any hobby expenses offset any other income that you have. You also can’t carry undeducted hobby forward under these rules and deduct them in future years.
There is a downside of being presumed a business. You’ll become subject to business taxes, such as employment tax. These taxes really are equivalents to those incurred by employees, so don’t think of them as an unreasonable impost. The Uwazi website has a detailed article here on business taxes.
Does the types of corporation, LLC or sole trader matter?
Yes they do. The IRS presumes non tax pass-through corporations (eg C Corps) to be a business, not a hobby. These businesses are not subject to the hobby rules. For all other situations, hobby vs business rules apply.
What makes my operation a business and not a hobby?
Short answer: it depends!
There are several approaches that the IRS takes. If you have historical profits, the IRS may presume your operation a business. If not, then there are nine factors that are considered. The balance of these factors leads to a conclusion about whether your operation is a business or a hobby.
The IRS presumes your activity to be a business if it has generated a profit in 3 out of the last 5 years. The five years includes the current year. This presumption depends on the general nature of your activity not substantially changing. Certain horse related operations only need to show profit 2 out of the last 7 years for this concession. If your operation meets this requirement, you are a business and can use normal deduction rules (including deducting to the point of a tax loss).
Elect to have the IRS presume the activity is for profit
If your activity is just getting started, you won’t have historical profits to demonstrate you are a for profit business. You can elect to have a period of grace to build up your history. You do this by filing a Form 5213. Be careful though. For most businesses, you’ll need to have 3 years of profit once your first 5 years is up. If you don’t, the IRS could claw back some of the deductions you previously made over those 5 years.
Nature of the activity
If you don’t meet the historical profits rule, and you have not filed a Form 5213, the IRS will use nine factors to determine if an activity is a business:
- do you carry on the activity in a businesslike manner
- does your time and effort that you put into the activity indicate you intend to make it profitable
- do you depend on the income from the activity for your livelihood
- are your losses due to circumstances beyond your control, or are they to be expected during the start-up phase of your type of business
- do you revise your methods of operation, attempting to improve profitability. This could be measures to improve revenues or manage costs
- can you show that you have, or have effective access to, the knowledge needed to carry on the activity as a successful business
- do you have a successful track record in being profitable in similar activities in the past
- does the activity make a profit in some years
- do you expect to make a future profit from the activity’s assets appreciation. This factor will apply to some businesses that develop assets and incur losses until they realize (sell) those assets at an expected point in the future
There’s no hard and fast rule about how many of these factors you need to meet. It’s a matter of judgement. The more factors you meet, the stronger your position to claim that your operation is a business. The nature of some activities will dictate that a few factors will be decisive, while for others, it may depend on most of them.
Each of the nine factors are detailed more extensively on the Electronic Code of Federal Regulations website.
What can you deduct?
If you are a business, you can deduct all business expenses under the normal rules. Capital items are depreciated, rather than deducted outright. You can deduct allowable expenses beyond the level of income. If your organization is a pass-through tax entity (most LLCs, S Corps, etc), then you can deduct certain personal items on your return as well. These personal deductions don’t create business losses. This is important for the 3 years of profits out of 5 year rule, because it is only if your deductible business expenses exceed business gross income do you have a business loss.
If you are a hobby, you can only deduct your hobby expenses to the amount of your hobby income. You can’t create a taxable loss from your hobby. This is true for the current year, but you also can’t carry any hobby loss forward or claw back from previous years. In addition, you can only deduct items specifically permitted on a “Schedule A, Itemized Deductions” about your hobby deductions. Typical deductions include:
- State and local taxes such as sales taxes and state income tax. You can’t deduct some state taxes like gasoline tax, certain assessments, and license fees. These deductions are limited to $10,000 for a couple. You have to choose if you are going to deduct state/local sales taxes vs income tax. This is because you can’t deduct both. You will want to use separate ledger accounts in your accounting system to keep track of these so you can choose which one is better to deduct
- Loans to support your hobby are not for business purposes. This is because your hobby is not a business. You generally can’t deduct interest on these loans
- If you have losses from a federally declared disaster
It matters if the IRS presumes your activity to be a business or otherwise a hobby. Businesses have greater flexibility in dealing with tax losses and can generally deduct their expenses. On the other hand, hobbies are significantly limited in what they can deduct.
If you have made profits more often than not in the last 5 years, the IRS will presume you to operate a business. If you are starting out, you can file a Form 5213 to give you time to get profitable. Otherwise, it comes down to nine factors about the nature of your activity.