Handbook / Self-employment tax and 1099s

Hobby vs business: how the IRS tells them apart and why it matters

Plenty of businesses start as hobbies: selling crafts, photography, baking, restoring furniture. At some point the question arises: is this a hobby or a business for tax purposes? The answer affects where income goes on your return, how expenses are treated and whether self-employment tax applies. The IRS does not use a single test. It looks at the whole picture.

Why it matters

If it is a business, you generally report income and expenses on Schedule C, deduct ordinary and necessary business expenses, pay self-employment tax on net earnings, and may be able to use business losses against other income, subject to the rules.

If it is a hobby, the IRS says income from an activity carried on with no intention of making a profit must still be reported, on Schedule 1 of Form 1040. Hobby expenses are treated very differently from business expenses, so check the current IRS rules for the year you are filing.

The IRS factors

The IRS lists key questions to consider. They fall into a few themes.

Is it carried on like a business?

• Do you keep complete and accurate books and records?
• Do you do it in the same way as similar profitable activities?
• Do you change methods to improve profitability?
• Do you advertise or promote it?
• Do you work to secure suppliers or products the activity needs?

Expertise

• What is your expertise, or your advisors' expertise?
• Have you prepared by studying accepted business, economic and scientific practices?
• Do you follow accepted business practices or expert advice?

Time and dependence

• Is it a main source of income?
• Do you spend much personal time and effort on it, especially if it has no personal or recreational aspects?
• Do you pursue it full time or part time?
• Do you employ competent and qualified people?

Profit history and expectations

• Have you made, or do you expect to make, a profit?
• Have you turned similar activities from unprofitable to profitable before?
• Do you expect profit from appreciation of assets used in the activity?
• Is it profitable in some years, and how much?
• Are losses normal for the startup phase, or beyond your control, such as disasters or depressed markets?
• Do losses continue beyond the period normally needed to become profitable?

Personal pleasure

• Does the activity have elements of personal pleasure or recreation?

The IRS stresses that all factors, facts and circumstances must be considered, and no one factor is more important than another. Enjoying your work does not make it a hobby, and one loss does not either.

Running it like a business

If you intend to make a profit, act like it:

1. Separate the money. Open a business bank account.
2. Keep books. Record all income and expenses; see bookkeeping for the self-employed.
3. Write a plan. Even a one-page business plan shows intent and direction.
4. Price for profit. Charge enough to cover costs and pay you.
5. Market it. Promote your products or services.
6. Learn and adapt. Take courses, get advice, change what is not working.
7. Register where required. Get licenses and a sales tax permit if you sell taxable goods.
8. Track time. Record the hours you put in.

These steps are not a checklist that guarantees business status, but they reflect the factors the IRS looks at.

Common situations

Craft and online sellers. Occasional sales of personal items differ from buying or making goods to sell for profit. See selling online taxes.

Side hustles. A side business can be a real business even if you have a full-time job. See side hustle taxes.

Activities with ongoing losses. Year after year of losses without changes to improve profitability can suggest a hobby. Review your approach and records.

Records that support business status

• business plan and pricing
• books and bank statements
• marketing materials and listings
• contracts and invoices
• training and advice received
• a log of time spent

When to get advice

If you have losses you want to deduct against other income, or the activity mixes business and personal enjoyment, a tax professional can help you assess the factors and keep the right records.

The IRS weighs many factors, none decisive: run the activity like a business with books, a plan, marketing and changes to improve profit; hobby income is still reportable, on Schedule 1.