Is It a Hobby or a Business?

By Dr. John L. Stancil
Tax Analyst, WebTaxCenter.com

You didn’t start out to have a business, it was mostly a hobby. But as time went on, you became more and more involved in the activity, spending more money, earning more revenues. Or maybe you just had a lot of spare time on your hands, so you decided to try and make a few bucks on the side. Perhaps you started selling stuff on eBay. You’ve had a bunch of losses, but you’ve made some money every now and then, too.

Now it is tax time. Do you report this income? Can you deduct your expenses? Where do you do this? Over the years this has been a dilemma faced by many taxpayers. Many of them decided they had a business and completed a Schedule C, showing big losses. The IRS has some very specific guidelines about what it takes to be a business. If you don’t meet these guidelines, the IRS says you have a hobby and all those losses cannot be deducted.

The IRS first states that if you make a profit for three out of five years, it is presumed that you have a profit motive and your activity will be treated as a business. If you are breeding, showing, training, or racing horses you only have to show a profit for two out of seven years. Notice that we said this is a presumption, it is not always conclusive that the activity is a business just because there is a profit. There are a number of factors that the IRS considers in deciding if there is a true profit motive, if you have a hobby or a business. No one factor is overriding, they are considered as a whole.

Factors Considered by the IRS

The first factor is the manner in which you carry on the activity. Do you maintain complete and accurate records? Do you treat it like a business, trying new methods to improve profitability? Related to this is the expertise of the taxpayer or his/her advisors. If the business requires special knowledge or training and the taxpayer or the taxpayer’s advisors possess this knowledge, it is seen as indicating a business.

The time and effort spent on the activity is another factor. Does the taxpayer spend substantial time and effort in the activity in an effort to generate profits and grow the business? Does the taxpayer have a history of success in similar endeavors?

Even if there is no profit, but there is an expectation that assets used in the activity may increase in value the activity may be termed a business. The history of income or losses is also considered. Occasional small profits coupled with frequent large losses is a negative factor even if the profits are generated in three of five years.

A very important factor is the financial status of the taxpayer. If the taxpayer has little income or other resources there is more likelihood that it will be considered a business even in the face of losses. On the other hand, if the taxpayer has a large income, the activity may be seen as a way to reduce taxable income and be classified a hobby.

Another factor is if there is an element of personal pleasure or recreation. If this is the case, a lack of profits may indicate a hobby. For example, someone may enjoy restoring furniture. They do this as a sideline, but never seem to make a profit at it. It is likely to be considered a hobby.

It’s a Hobby – What Can I Deduct?

If what you have is a hobby, the income must still be reported to the IRS. This income is reported as “Other Income” on line 21 of the 1040. “But what about my expenses?” you say. “I spent a lot of money on this, can’t I deduct my expenses?” Fear not, you may be able to deduct expenses equal to the amount of your income.

Gross income as defined in this context is your total receipts minus cost of goods sold. You reduce your total sales by the cost of what was sold to get gross income. This is the number reported on line 21 of the 1040.

Hobby expenses may be deducted as itemized deductions on Schedule A. If you have these expenses, but do not itemize, you’re out of luck. You don’t get the deduction, but still must report the income. Hobby expenses are divided into three categories, with different treatment for each.

Category one expenses are known as “otherwise deductible,” meaning that you may deduct these without regard to hobby income. Items such as mortgage interest and taxes on your home are fully deductible even if some of these expenses can be allocated to your hobby. They are reported as interest and taxes as if they were not associated with a hobby.

Category two expenses can be deducted only if category one hobby expenses do not exceed the income from the hobby. These expenses are reported as miscellaneous itemized deductions subject to the 2% limitation. This means that you can only deduct the portion of these that exceeds 2% of your adjusted gross income. Advertising, interest, insurance, and wages associated with the hobby are examples of these expenses.

Category three expenses only come into play if there is still income after deducting expenses from the previous two categories. This category is reported the same as category two, as miscellaneous itemized deductions. These expenses are most commonly depreciation on the assets used in the hobby.

What if it IS a Business?

If the activity is a business, you report the income and expenses of the business on Schedule C. It is considered a sole proprietorship. If you have more than one business, you should file a Schedule C for each business. If you and your spouse or another person operate the business, you have a partnership and should file a partnership return (Form 1065).

The IRS guidelines for business expenses state that they must be “ordinary and necessary.” An ordinary expense is one that is customary in the type of business that you are conducting. For example, an attorney would not be able to deduct the cost of a power saw. But for someone with a business in the construction industry, the power saw would be an ordinary expense and could be deducted. A necessary expense is one that is helpful and appropriate for a particular trade or business. For example, the purchase of an accounting program to keep track of your income and expenses would be considered a necessary expense even though you could keep these records by hand.

If you show a profit from your business, you will also need to pay self-employment taxes. These are determined by including Schedule SE with your tax return.

For additional information about tax topics, you should consult your CPA or other tax professional. Internet resources include www.irs.govwhere you can find copies of all IRS forms and publications. Also, www.webtaxcenter.com has a great deal of tax advice and other tax information

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Dr. John L. Stancil, a tax analyst for WebTaxCenter.com, has been a member of the Florida Southern College faculty since 1998. He received his bachelors degree from Mars Hill College and holds a M.B.A. from the University of Georgia. He later earned his doctorate in accounting from the University of Memphis. He holds four professional certifications, including CPA, CMA, CFM and CIA. Stancil has received the Florida Institute of CPAs 2005 Outstanding CPA in Public Service Award. (This award is given annually to a Florida CPA who has demonstrated significant contributions through community and civic activities.) He has also been recognized as the Expert of the Month on several occasions by allexperts.com.

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