Whether an activity is classified as a business or a hobby can make a significant difference when it comes to taxes. Hobby losses are subject to “hobby loss rules”, under which the deductible expenses are limited to the amount of income generated by the activity. Even the expenses that can be deducted are subject to a 2% of adjusted gross income (AGI) floor. Deductions from business activity income, however, may exceed income and are fully deductible.
To illustrate, let’s suppose John, a photographer, decided to start a side business, taking pictures at weekend weddings. He earned $4,000 and incurred travel expenses of $3,000 and supply expenses of $2,000. If John’s side job is classified as a business activity he may deduct both expenses to arrive at a $1,000 loss. If it’s classified as a hobby, however, he may only deduct expenses to the extent of his earnings $4,000(assuming those expenses exceed the 2% of AGI floor), and no loss would be allowed.
While the difference is clear in terms of the tax ramifications, whether or not to classify an activity as a hobby is a rather complex matter.
For an activity to be considered a business, it must be engaged in for profit. How will the IRS determine the intent of the business owner? Here are several factors they consider:
- How the activity is handled – To be considered a business an activity must be conducted in a businesslike manner. The taxpayer can establish this by maintaining separate personal and business bank accounts, and keeping records and books, maintaining a website
- Historic performance- A long streak of losses indicates a hobby, whereas sustained earnings indicate a for-profit activity
- Nature of the activity- If the activity can provide some sort of recreation or other personal motive, it points to hobby status. If, however, there is no conceivable personal motive it points to business activity
These are only a few of many factors the IRS may consider. We recommend that you consult with a tax professional to determine the proper classification of your business activity.