Taxation Variances: Hobby Earnings vs. Business Earnings

In today’s world, many people have a side gig, in addition to their regular job. It could be teaching fitness classes or selling skincare products, often stemming from their hobbies. Understanding whether your activity is considered a business for tax purposes is crucial.

For instance, if you’re just starting your business and, like most new businesses, you’re facing startup costs and reporting losses, you can deduct those expenses on your tax return. This can be a significant help for a new business where every dollar matters. Let’s find out how to distinguish between a hobby and a business for tax purposes.

What Separates a Hobby from a Business?

Most people pursue hobbies for fun, not to earn money. In contrast, businesses are all about making a profit and have to report their financial results at the end of the tax year.

Is it a hobby or a business for taxes?

To figure it out, ask yourself:

  • Are you keeping good records?
  • Do you want to make money, and does your time and effort show that?
  • Do you rely on this money to survive?
  • Are you trying to make your business more profitable?
  • Do you know enough about it?
  • Are your losses from startup or beyond your control?
  • Did you profit from a similar activity before?
  • Was it consistent or up and down?
  • Do you expect future profits?

Be honest and base your answers on facts. If you mostly said ‘yes,’ it’s likely a business. If mostly ‘no,’ it’s probably a hobby.

For extra clarity, consider this: If you’ve been profitable in three of the last five years (or two of the last seven for horse-related stuff), the IRS sees it as a business.

If your business could be seen as a hobby, keep detailed records and make a short-term plan to boost profits. This helps if you ever face an audit.

How much hobby income is tax-free?

If you make more than $400 in a year from your hobby, you must report it on your taxes as self-employed income. The IRS requires you to file Schedule SE and pay self-employment tax if your net earnings reach $400 or more. You can also deduct necessary business expenses.

Do I need a sole proprietorship or LLC for my side business?

If your hobby turns into a business, don’t worry about setting up a formal business entity right away. The IRS will automatically consider you a sole proprietor if you’re the sole owner of the business.

What’s the deal with business taxes?

Business income gets taxed, and if you’re self-employed, you also pay a 15.3% self-employment tax for Medicare and Social Security.

You can lower your taxable income by claiming business deductions for things like startup costs, internet and phone bills, and travel expenses. If your business isn’t making money, you might even report a loss. Use Schedule C for reporting your business income and losses.

And what about hobby income?

Hobby income needs to be reported on your federal tax return, just like business income. You’ll owe income tax, but no self-employment tax if you’re a hobbyist. On your Form 1040, you’ll find a section for “Other Income” (Schedule 1, line 8) to report your hobby earnings.

But there’s a change. If your hobby makes extra cash on the side, you can’t deduct hobby-related expenses to offset your income anymore. Before 2018, you could deduct these expenses up to your hobby income amount, but not anymore.

These hobby loss rules apply to small businesses like sole proprietorships, partnerships, and S corps, not to corporations.

When you use TaxAct®, we’ll guide you through the process, making it easy to report your hobby income and choose the right tax forms. 

Here’s what you need to know:

  • Match income and expenses. If the money you make from your activity is more than what you spend on it, the IRS is less likely to question if it’s a business.
  • Keep good records. Be organized and professional in how you handle your activity. Good records and a businesslike approach can make a difference.
  • Show a profit three years out of five. If you can turn a profit in three out of every five years (or two out of seven for horse breeding), the IRS will assume you’re in it to make money. This assumption is helpful because it avoids a more complicated test.
  • Plan your income and expenses. You can control when you receive income and when you have expenses. This control can help you show a profit in three out of five years.
  • Delay the profit determination. You can choose to wait until the fourth year for your “business” (or sixth year for horse-related activities) to determine if you’re in it to make a profit. To do this, file Form 5213. But be cautious; it may draw attention to the profit motive issue and extend the IRS statute of limitations.

Whether you have a hobby or a business, good record-keeping is essential for tax filing. You can also check out IRS publications for more guidance.

Bottom Line 

It can be frustrating if the IRS suddenly calls your business a hobby. This might happen if your business consistently reports losses or doesn’t meet IRS business criteria.

To show that your business is legitimate, keep good records and save receipts. Detailed bookkeeping and a written business plan can help you prove your business is for profit if the IRS questions it.