When it comes to pursuing passions or engaging in activities, the line between a business and a hobby can sometimes be blurry. This article aims to shed light on the distinctions between the two, particularly concerning tax implications. Whether you’re a budding artist investing in your craft or an individual considering the tax benefits of your activities, understanding the difference is crucial.
The Intent Matters
At the core, the disparity between running a business and pursuing a hobby boils down to intention. Is the individual engaging in the activity with the primary goal of making a profit, or is the enjoyment of the activity the driving force with little concern for financial gain?
The Internal Revenue Service (IRS) provides guidelines to assist in making this determination, emphasizing the importance of intention. The consequences of this classification are significant, affecting the deductibility of expenses and the taxation of income.
Tax Implications of Business vs Hobby
If an activity is classified as a trade or business, the expenses incurred are deductible as business expenses, and any net income is subject to self-employment tax. Conversely, if an activity is deemed a hobby, its financial aspects are treated differently. Hobby income is reported as miscellaneous taxable income, and it is not subject to self-employment tax, as it is not generated by a business activity.
Since the Tax Cuts and Jobs Act (TCJA) of 2018, expenses incurred in pursuing a hobby, often referred to as “hobby losses,” are no longer deductible for most taxpayers. This change has eliminated a previously available tax benefit, making it crucial to accurately classify activities.
Classification Rules and Presumptions
To determine if an activity is a business or a hobby, one of the clear-cut IRS rules is based on the financial results generated by the activity. According to IRS Publication 535, 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. For specific activities like breeding, training, showing, or racing animals, a profit is required in two out of seven years to meet this presumption.
If an activity does not meet the presumption, the IRS provides a list of factors to consider in determining its classification. These factors include:
- Businesslike Manner: Is the activity carried out in a businesslike manner with complete and accurate books and records?
- Intent to Make Profit: Does the time and effort put into the activity show an intention to make it profitable?
- Dependency on Income: Does the individual depend on income from the activity for their livelihood?
- Nature of Losses: Are losses due to circumstances beyond the taxpayer’s control or normal for the startup phase?
- Profitability Over Time: Does the activity make a profit in some years, and if so, how much profit is generated?
- Adaptation for Profitability: Is there a willingness to change methods of operation to improve profitability?
- Knowledge and Expertise: Do the taxpayer and their advisors have the knowledge needed for a successful business?
- Expectation of Future Profit: Can the taxpayer expect to make a future profit from the appreciation of assets used in the activity?
- Past Success in Similar Activities: Was the taxpayer successful in making a profit in similar activities in the past?
- Personal Motives: Does the taxpayer have personal motives, such as general enjoyment or relaxation, for carrying out the activity?
For breeding, training, showing, or racing animals, this presumption requires a profit in 2 out of 7 years. If your activity qualifies under this presumption, then you can report it as a business activity and take business deductions and losses in the years in which they are incurred unless other factors to the contrary overcome the presumption.
If your activity does not qualify under this presumption, however, all is not necessarily lost. The IRS has outlined a series of factors that you can consider to determine whether your activity will be treated as an active trade or business or a hobby for tax purposes.
