Tax Considerations of Turning Your Hobby Into a Business
For many, owning a small business is the American dream. However, the tax situation incurred by turning your hobby into that business can be a real American headache.
Still, who can resist the allure of a job that’s loved and makes the hours fly? You don’t have to resist it. Just be sure of what you’re getting into with Uncle Sam.
Taxes and an Employment Trend
The gig economy has turned many taxpayers from hobbyists to moneymakers.
A 2022 survey found that around 59 million workers in the U.S. are now classified, for tax purposes, as independent workers, more than a third (36 percent) of the U.S. workforce. Cited IRS data shows that the number of taxpayers who earned income from gig work tripled from 2017 to 2021.
So, even if the results of a hobby are, for now, are just to sell one at a time online on sites like Etsy and you dream of bigger money for your creativity, you should know that the federal tax regulations affecting you are getting clearer and more precise. The IRS gives nine points to consider when determining whether an activity is a hobby or a business:
Is the activity carried out “in a businesslike manner” and do you maintain complete and accurate books and records?
Does the time and effort you put into the activity show you intend to make it profitable?
Do you depend on income from the activity for your livelihood?
Are any losses due to circumstances beyond your control or are they normal for the startup phase of your type of business?
Do you change methods of operation to improve profitability?
Do you and your advisers have the knowledge needed to carry out the activity as a successful business?
Have you been successful in making a profit in similar activities in the past?
Does the activity make a profit in some years and how much profit does it make?
Can you expect to make a future profit from the appreciation of the assets used in the activity?
Yet beyond applying these questions to determine a taxpayer’s “profit objective,” the IRS admits that determining the taxpayer’s intent is unavoidably very subjective and depends on the intent of a particular individual. The agency’s own literature says it can often prove highly difficult to figure out the difference between a legitimate business devoted to making a profit and an activity that is not.
Filing and Deductions
Your objective when filing taxes when you have a hobby/business resembles filing taxes under any other circumstances: You’re trying to pay your taxes fairly and get the most you’re legally entitled to, and you’re trying to avoid audit red flags.
One of the first red flags in hobby-vs.-business is that declaring a loss three years out of a consecutive five years will mean that the IRS will declare your activity a hobby and disallow almost all business tax deductions you try to take. Many often call this the “five-year rule,” in that generally your activity must make a profit three out of five years for the IRS to consider it a business.
Businesses file an annual tax return and calculate and pay taxes (federal and state, where applicable) every calendar quarter. The self-employed, for example, calculate and pay estimated taxes for that quarter in April, June, September, and January. Quarterly business taxes can also include employment and excise taxes. Pay estimated quarterly taxes if you expect to owe more than $1,000 on your annual income taxes.
Deductions can improve a tax situation, of course, though the rules concerning business and hobby deductions can be specific and complex.
Businesses, including home-based businesses, can deduct from taxes a variety of expenses that are ordinary, necessary, and typical for an industry. These expenses can include all or portions of professional expenses, some meals and entertainment, and some vehicle expenses and the costs of maintaining an office, among others. Small-business income, losses, and expenses are filed on the IRS Schedule C, “Profit or Loss from Business (Sole Proprietorship),” which is filed with the annual federal tax return.
Taxpayers may also have gross income even from a hobby; Internal Revenue Code Section 183 allows taxpayers to deduct some of the expenses from the activity even without establishing the profit intent, though deductions can’t exceed the gross receipts for the activity. Deductions for hobby activities are itemized deductions on Schedule A of Form 1040. (Fewer taxpayers itemize these days since the 2017 Tax Cuts and Jobs Act greatly increased the standard deduction.)
The taxpayer should probably only try this filing with the support of a professional tax preparer or tax expert. How complicated can this question get? Consider the 2021 case of Carl L. Gregory and Leila Gregory v. Commissioner, “a graphic lesson,” said one observer, “on the great divide that can exist between treatment of deductions taken above the line and those taken below.”
The taxpayers in question ran a Caribbean boat-chartering business and were eventually unable to deduct their “hobby” expenses for 2014 and 2015 because the amount – almost $656,000 – did not exceed 2 percent of their adjusted gross income (the rule for such deductions prior to the TCJA, which may be reinstated after 2025). The Gregorys argued that the expenses should have been a factor in calculating their AGI, a.k.a. above the line. They lost but have appealed.
Before you decide to transform your hobby into a business, understand what the tax implications may be for each. And how auditors might one day look at your activity:
“A taxpayer’s mere statement of [profit] intent is given less weight than the objective facts … The regulations state that no one factor, or simple mathematical preponderance of the factors is conclusive. And even factors not listed in the regulations may be the deciding factor.”
If you take business deductions, be ready to back up that you’re now in this business to make a profit.
Example
Dave’s dad owned a crafts shop, and Dave has always loved working with flowers. Dave decides to start selling plastic floral arrangements online. He keeps records of the supplies and other expenses involved with the hobby from the moment he makes his initial sale.
In the first and second years, the pastime costs three times what Dave makes, and he only spends about 10 work hours a week on it; he still calculates and pays estimated taxes on the income. Since he’s conducting this activity and calculating these taxes while the TCJA is still in effect, he does not deduct the itemized expenses under Sec. 183. He completes his own tax return.
In the third year, Dave makes a 5 percent profit; he realizes this mid-way through the year, and he begins filing a Schedule C with his annual 1040 federal return. He begins documenting all expenses more completely and engages a professional tax preparer to make certain he’s taking all legitimate deductions and filing all necessary documents to run a business. Dave realizes that soon he’ll meet all nine IRS conditions for a business, and the IRS will consider his activity a business.
In the fourth and fifth year, he turns a bigger profit, fulfilling the “five-year rule.” Dave also starts spending 40-plus work hours a week on his activity; he quits all other work. He starts attending conferences and shows involving small online retail businesses and plastic floral arranging. He learns how to work more economically with suppliers and web marketplaces. In short, Dave begins to learn and incorporate into his activity more aspects of an industry and profession.
Summary
Transforming a hobby into a money-making business is a dream – and a reality for many people. The tax implications are hardly prohibitive, but the level of attention must be constant. A change in definition can surprise a taxpayer unless the hobbyist/business owner understands tax guidelines, timeframes, deductions, and the need to document thoroughly as an activity evolves.
