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Starting a Business or Earning from a Hobby? Consider the Tax Implications

Many people enjoy hobbies that cost quite a bit of cash to maintain and may even earn a little bit back. Unfortunately, the expenses of a hobby can only be deducted from your personal taxes up to the amount your hobby earns. For example, one hobbyist makes quilts and spends an average of $500 per month on materials and travel to quilt shows. He won two prizes last year of $1000 each, and sold several quilts for a total of $2500. As a hobby, only up to $3500 of the expenses could be deducted, even though about $6000 was spent. If the activity was classified as a business instead, all of the "ordinary and necessary" expenses could be deducted as a business loss. The question is, at what point can a hobby be reclassified as a business?

There are a number of factors that separate a hobby from a business, most of which are based on the profitability of the activity. The IRS refers to hobbies as "not-for-profit activities" -- meaning that you do not do the activity with the intention of clearing a profit. If you are doing what you do just for fun and really don't care whether you turn a profit or not, it is a hobby. It is possible for a hobby to make a profit, but that is usually a fluke. A hobbyist does not take any measures to ensure a profit is made, and does not generally maintain records and incorporate business principles in managing the activity.

The IRS standard for an activity to even qualify as a business is that a profit is earned in at least three of the last five years. Of course, if you have not kept records or have recently started this activity, you may not have these types of records. Consider the likelihood that this will be true over the next five years. If you are willing to treat the activity as you would any other business - by monitoring the financials, maintaining business records, and finding ways to make it profitable -- you can report it as a business, even if you show a loss in the current year. If, however, you continue to report a loss year after year, and do not show a profitable year for several years straight, the IRS may take a second look at your taxes (read: IRS audit)...definitely not an outcome worth the few hundred dollars you might save on your annual tax return.

Generally, a hobby becomes a business when and if your purpose for the activity is to make a profit, you depend on the income from the activity, and/or you actually do profit from the activity most years. The advantage of filing the activity as a business is that you can write off your losses when they occur, and the disadvantage is that you are taxed on the profits the other years as additional ordinary income. The earnings in a profitable year do not have to be extravagant. Technically, earning one dollar more than you spent is turning a profit, though the IRS might be suspicious if you profit only one dollar per good year and lose thousands on a bad year!

The bottom line is that if you want to turn your hobby into a business for tax purposes, you actually need to turn it into a legitimate business. A legitimate business makes operational changes to control expenses and increase income. It maintains basic accounting records and follows basic business principles. The owner's primary motivation in business is to make money, and most business owners would not continue with an activity that doesn't improve their personal wealth. If you are not interested in the effort required to turn your hobby into a business, simply continue to keep your receipts so that you can write off expenses up to the amount of money your hobby brings in.

About the Author

LaunchX.com is dedicated to training entrepreneurs to turn their good ideas into great companies. The LaunchX System provides step-by-step education in the mindset and skill set entrepreneurs need to succeed. Our program includes intensive seminar training, key business software, and specialized workbooks that teach you the fundamental skills you need to achieve your financial and worklife goals through entrepreneurship. Register today for our introductory course and see what LaunchX can do for you!