Every business idea, no matter how big or small, starts somewhere. Whether it came from a random daydream or a well thought out business plan, your idea was fueled by something you thought the world needed.
Perhaps you had another job or responsibility you were attending to at the time, and you weren’t able to devote all your time and resources to your new idea. Instead, you kept it as a side project which turned in to a fun little hobby.
While keeping your main job and running a hobby business can be fun and energizing (after all, you’re running your own business now!), there are certain tax implications that must be taken into consideration when your business idea is just a hobby.
Your tax liability will be affected depending upon whether your work is classified as an actual business or as a hobby. Here are nine factors from the IRS regulations used to determine if an activity is a business or a hobby:
- Do you conduct the activity in a businesslike manner? This includes keeping accurate books and records and pursuing operating methods and business techniques with the motive of turning a profit.
- Do you have expertise in the business?
- Do you devote much time and effort in carrying on the activity?
- Are the assets of the activity expected to appreciate in value?
- Have you had success in starting a new business or converting an unprofitable business into a profitable one?
- Is the history of income or losses from the activity indicative to a profit motive? If you have continued losses, this may suggest that the activity is a hobby. There is a safe-harbor rule that states if you generate a profit in three out of five years, your activity is deemed a trade or business. For horse racing, breeding, training or showing the test is two out of the last seven years. The IRS can still disagree, but the burden of proof to show the activity is a hobby versus a trade or business has now shifted from you to them.
- What is the amount of profits in relations to losses? An occasional small profit in an activity which generates large losses or from an activity in which a large investment has been made would not necessarily translate into a profit motive.
- Do you have substantial income or capital from other sources? If so, losses from the activity may generate tax benefits by offsetting income from other sources, which is generally not looked kindly upon by the IRS.
- Does the activity present personal pleasure or recreation? The IRS is more likely to attack an activity that has recreational elements such as racing, horse or dog training or showing, or even weekend farming, rather than tax preparation services (although we think this is kind of fun!).
So what does this mean for you? Any form and amount of income, no matter where it is coming from, is taxable and should be reported. However, hobby activities are reported differently than trade or business activities and have certain limitations. On a positive note, hobby activities are not subject to self-employment tax. However, expenses related to hobby activities are only deductible as itemized deductions subject to 2% of adjusted gross income. Taxpayers who utilize the standard deduction do not receive any benefit from these expenses and those with higher income will also be limited. Additionally, retirement plan contributions, self-employed health insurance and an array of other deductions cannot be used to offset hobby income.
The moral of the story…
The IRS needs to know about any money you’re bringing in, whether it’s from your daily job, or the hobby app building company you run from your garage. If your business is just a hobby, remember you still need to report it and planning can go a long way in terms of tax benefits and pitfalls.