When you have an activity that is both fun and brings in money, you need to figure out whether you’re a hobby or a business. Often, you need to figure out what tax rules to follow. Other times, you can choose what’s best for you. Here’s how to figure out when it’s better to be taxes as a hobby or a business.
What rules determine whether you’re a business or a hobby?
To determine whether you’re a business or a hobby, you start with the hobby loss rule. If you make a profit in three out of five years, you’re presumed to be a business. If you take a loss in three out of five years, you’re presumed to be a hobby.
Presumed means just that — presumed. The IRS makes a final decision based on the following factors.
- Whether the activity is carried out in a businesslike manner and the taxpayer maintains complete and accurate books and records.
- Whether the taxpayer’s time and effort put into the activity show they intend to make it profitable.
- Whether they depend on income from the activity for their livelihood.
- Whether any losses are due to circumstances beyond the taxpayer’s control or are normal for the startup phase of their type of business.
- Whether they change methods of operation to improve profitability.
- Whether the taxpayer and their advisors have the knowledge needed to carry out the activity as a successful business.
- Whether the taxpayer successfully made a profit in similar activities in the past.
- Whether the activity makes a profit in some years and how much profit it makes.
- Whether the taxpayers can expect to make a future profit from the appreciation of the assets used in the activity.
When can an activity be either a business or a hobby?
Many activities can be either a business or a hobby. For example, there are professional golfers and amateurs that play for fun on weekends.
Racehorse owners are largely responsible for the current hobby vs. business tax rules. There were several court cases where people owned racehorses as a hobby with no attempt to make a profit but were saying they were a business to deduct the horse losses from other income. The courts ruled that wasn’t allowed, and they had to classify themselves as a hobby.
Another common situation is sports officials. Many do it for the love of the game and only make a small amount of money, especially after their expenses. However, others can and do make it a profitable endeavor.
You may even see Uber drivers saying they drive as a hobby. Most people Uber as a job, but some bored retirees do it just for something to do who could count as a hobby if the math checks out.
Why does it matter for taxes if you’re a business or a hobby?
There are four key differences in taxes between a business and a hobby.
- Business profits are subject to 15.3% in self-employment taxes. Hobby income is not.
- You can’t deduct hobby expenses from hobby income. If you received $2,000 but spent $1,500, you still have $2,000 in hobby income.
- Business income is taxed based on your net profit (after deducting expenses). Hobby income is taxed based on the full amount of money you receive.
- Business income is earned income. Hobby income is not. You need earned income to be able to contribute to certain retirement accounts or to qualify for certain tax credits like the Earned Income Tax Credit. Earned income also counts towards your Social Security earnings record. Hobby income does not.
One thing that stays the same is that income taxes apply to both hobby income and business income.
You can learn more about hobby taxes here.
Example: $1,000 income, $0 expenses
If you have $1,000 in income as a business, you’ll pay $153 in self-employment taxes. You can deduct one-half of your SE tax to get your taxable income for income taxes. That works out to $1,000 – $76.50 = $923.50. Most people will qualify to deduct 20% for the Qualified Business Income deduction. 80% of $932.50 is $738.80. Assuming you’re in the 22% tax bracket, your income tax is $162.54. Your total taxes are $315.54.
If you have $1,000 in income as a hobby, you pay only income taxes. Assuming you’re in the 22% tax bracket, your income tax and the total tax is $220.
Example: $3,000 income, $2,000 expenses
If you have $3,000 in income and $2,000 in business expenses, you have a $1,000 net profit. Since you get taxed based on your net profit, the math is the same as above. Your total taxes are $315.54.
If you’re a hobby, you can’t deduct your expenses. You pay income tax on the full $3,000. If you’re in the 22% tax bracket, that’s $660.
Is it better if you’re a business or hobby for tax purposes?
As you can see from the above examples, the math could go either way, depending on your numbers. You’ll need to do the math for your situation and consider how your numbers might change from year to year. You’ll also need to consider the IRS factors, like whether you have a profit motive, and how they apply to your situation.
You can’t switch back and forth between being a business or a hobby every year based on what has a lower tax liability in any given year. That’s an easy way to get the IRS to audit your tax returns.
You can switch a legitimate business to a hobby or a hobby to a business if the circumstances warrant it. For example, you might have been engaged in an activity as your main income, taken a full-time job doing something else, and kept doing the activity as a hobby. If you make this kind of switch, be sure to carefully document what you changed and when.
Conclusion
In many cases, the IRS rules clearly define whether you’re a business or a hobby. Some business or hobby activities may be close calls where you can choose your tax status. Like any tax issue, you should keep good records to defend the position you take in case of an IRS audit. If you’re unsure about any tax implications, talk to your tax advisor before making any moves.
