Like many Americans, you may have started dipping your toe into a new business venture. Maybe you helped some friends redecorate their homes—and they paid you. Or maybe you started painting as a creative outlet and a few people have asked to buy your work.
When tax time rolls around, you may start to wonder if your new venture is considered a hobby or a real business. You’ve made some money, but does that automatically mean you’re a business owner?
Deciding whether you have a hobby or business is actually something the IRS gets to decide, and they have very specific criteria for the two. In this guide, we’ll explain how these classifications are decided and what each means for your taxes.
Hobby or Business: Does It Matter?
If you have a side gig, you may not think much about whether it’s a hobby or a business. Maybe you paint landscapes and, occasionally, someone wants to buy one of your pieces. Does this mean your hobby of painting is also a business?
To you, the distinction between a hobby and a business might not matter. If you get paid, that’s great! But to the IRS, there’s a big difference.
The difference comes down to how your expenses are treated. According to the IRS, if you don’t have a business, you cannot deduct expenses and you also can’t use any losses from the hobby to offset other income.
How the IRS Decides If You Have a Hobby or Business
Since it matters whether you have a hobby or a business, the IRS gives clear guidelines so you know how to classify what you do.
To be classified as a business, IRS publication 535 states that:
- You must be involved in the business with continuity and regularity, and
- Your primary purpose for engaging in the activity must be for income or profit.
How do you know if your painting business is engaged in making a profit? The IRS has nine factors you can use to decide. If you answer yes to most of these, you probably have a business that is engaged in making a profit. If not, the IRS likely will see your business as a hobby. The IRS factors are:
- Whether you carry on the activity in a businesslike manner and maintain complete and accurate books and records
- 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
- Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business)
- Whether you change your methods of operation in an attempt to improve profitability
- Whether you or your advisors have the knowledge needed to carry on the activity as a successful business
- Whether you were successful in making a profit in similar activities in the past
- Whether the activity makes a profit in some years and how much profit it makes
- Whether you can expect to make a future profit from the appreciation of the assets used in the activity
If you started your painting business with the goal of becoming profitable, you run it like a business and do regular bookkeeping, and you’re working regularly to sell your artwork at exhibits and online, there’s a good chance that the IRS will agree that painting isn’t a hobby, it’s a business.
If, on the other hand, you started painting without the intent of creating a business, you only sell a few pieces occasionally when someone happens to see them, and you don’t treat it like it’s a business, this will likely be considered a hobby for tax purposes.
It’s a bit subjective, but the IRS has the final say in whether you’re spending your time on a business or a hobby.
How Tax Treatments Differ for a Hobby vs. Business
While it may not seem worth the trouble to start a business if you don’t plan on making a significant amount of money, whether you have a hobby or a business can make a significant difference to your tax bill.
Deducting Hobby Expenses
Before the Tax Cuts and Jobs Act (TCJA), you could deduct hobby expenses up to the amount of income you earned from that hobby. If you earned $1,500 from selling your paintings, you could potentially deduct up to $1,500 of the expenses related to producing those paintings. They were included as a miscellaneous deduction that you could take if you itemized deductions.
The TCJA eliminated the miscellaneous deduction, thereby eliminating the option you had to write off your hobby-related expenses.
Now, if you earn an income from your hobby, you need to report (and pay taxes on) that income, while not deducting any of the expenses.
Deducting Business Expenses
If you’re running a business, on the other hand, you are able to deduct your business expenses. Many single-owner businesses are sole proprietorships and deduct allowable business expenses on Schedule C, which is filed along with your personal income tax form 1040.
If your business is a partnership, LLC, or corporation, business deductions would be made on those business tax returns.
Business deductions can be taken for a variety of expenses, including travel, supplies, home office, phone, and other utilities. So a painter running what the IRS classifies as a business can deduct expenses for paint, canvas, brushes, travel to painting locations, the cost of the painting studio, and so much more.
The hobby painter isn’t able to deduct any of those expenses, even if they made some money from their hobby that year.
What If Your Business Hasn’t Made a Profit… Yet?
When is a business considered a hobby for tax purposes? Is it when your business hasn’t made a profit?
The IRS knows that businesses don’t often make a profit right away, so they give you a little leeway with the profit requirement. You can still be considered a business if you have the presumption of profit. According to the IRS, “An activity is presumed carried on for profit if it produced a profit in at least three of the last five tax years, including the current year.”
If you’re worried about having enough time to show the IRS that you will make a profit, you can file Form 5213, which delays the IRS making a determination as to whether your business is a business or hobby. When you file this form, the IRS will wait five years to determine whether they will classify your business as a for-profit business. You’ll need to file this form within three years after the due date of your business’s first tax return.
Tips to Be Classified as a Business
If you’re earning money from an activity that you want to IRS to view as a business, rather than a hobby, there are a few steps you can take to help strengthen your case.
- Start your business with the intention of making a profit. This may mean writing out a business plan or not spending more on startup costs than is normal for your industry.
- Keep accurate books. Set up a bookkeeping system and keep your personal and business money separate.
- Register as a business. While this won’t automatically make the IRS see you as a business, it might be a good idea to register with your state as an LLC, partnership, or corporation.
- Work regularly for your business, on activities that will help it to become profitable. If you’re a painter, that could mean exhibiting your artwork, creating a website to sell it online, and spending time marketing.
If you have a side gig that you want the IRS to consider a business, it’s important to spend time being intentional about how you set up and treat it. It’s worth taking the time to get this right because how the IRS classifies your entrepreneurial endeavor can have a real tax impact at the end of the year.