Hobbies are great – in addition to benefiting our mental health by reducing stress, enabling social connection, and increasing happiness, hobbies can also generate some extra income. Here at Bryson Law Firm, LLC, we’ve seen many Taxpayers earn money from a hobby – landscaping, woodworking, embroidery, sewing, crafting – and it’s important to know that if your hobby produces income, it must be reported to the IRS on your tax return. Here are a few tips to make sure you stay compliant with your tax obligations so that you can continue to enjoy your hobby without the stress of a tax problem.
First, it’s important to know the difference between a hobby and a business. A business is an endeavor you pursue for the purpose of making a profit. Different from that, hobbies are often pursued for fun and recreation. Things the IRS looks to when determining whether an activity is a business or a hobby includes items such as whether the taxpayer carries out the activity in a business-like manner, whether the taxpayer keeps books and accounting records, the time and effort put into the activity to show it’s for a profit, whether they depend on the income for livelihood, whether losses are due to circumstances beyond the taxpayer’s control or are normal for the startup of the project, whether they change methods of operation to improve profitability, whether the taxpayer has the knowledge needed to carry out the activity as a successful business, successful in making a profit on similar activities in the past, etc.
Why does it matter how the activity is classified? Because a business can deduct expenses and potentially take a loss if the business is not profitable, but hobby losses aren’t deductible. In a for-profit business, the business owner can deduct ordinary and necessary business expenses in full. If the losses exceed the business income, it can also then offset other income on the owner’s tax return such as w-2 wages, etc. The Tax Cuts and Jobs Act removed the opportunity to claim non-business expenses as miscellaneous expenses on a Schedule A, so while hobby income must be reported, expenses cannot. This distinction is governed by the IRS’ “Hobby Loss Rules.”
So, what happens if you file as a business but operate as a hobby? The burden of proof is on the taxpayer to prove that a hobby-business is entitled to business tax deductions. The IRS can review your business situation via audit and decide on whether it is a legitimate for-profit business or a hobby. These audits typically occur if there were losses in the last 3 of 5 years and in these audits, the IRS will consider the factors discussed above. If you believe your activity to be a business but have suffered losses, you can submit an IRS Form 5213 within 3 years from the due date of your return for the first tax year you participated in this activity. The benefit here is that you’ll have another 2 years to attempt to reflect a profit, but if you do not generate it, the limit can be applied retroactively to the prior 3 years.
If you have recently started a business doing something you love and plan to report this to the IRS as a business vs. a hobby, here are a few things to consider:
- Set up a business entity and make sure you obtain all necessary business licenses and permits
- Consider a website
- Take the time to invest in setting up a set of books either through accounting software or a leger
- Open a separate business bank account and keep your business and personal expenses separate
- Make sure you’re taking advertising or marketing efforts
Also, don’t forget that whether or not your activity is a business or a hobby, if you sell goods, you need to be sure you comply with all State and local sales tax obligations.
If you have questions about your hobby-turned-income, contact Bryson Law Firm, LLC today!