Tax responsibilities and the timelines for when they are to be paid to the Internal Revenue Service (IRS), state and local municipalities differ for business owners and taxpayers who work in a full-time capacity for an employer. But when you generate supplemental income from a side project or hobby—even one you consider a “real” business —the rules around your tax liability, and whether you’re an entrepreneur earning taxable business income in the eyes of the IRS, begins to blur.
Here’s a look at some of the factors that determine hobbies from businesses, and why it makes a difference when you file your taxes.
Regardless of how you earn money, the IRS is clear in the fact that must report any income of $400 or more on a Form 1099-MISC. Assuming that tax was not withheld from that income and you’re not entitled to exemptions, you’re also expected to pay tax on the income you earn. But what if you incurred expenses in order to provide or produce the service or product, and that cost ultimately reduced (or negated) the profit you actually realized from the money you earned? The answer depends on whether income is generated by a hobby, or a business activity. Here are a few guidelines to determine which you have, according to tax law.
How long have you been doing your side gig? Opening a business often involves putting forth an investment to secure physical space, establish a website, source materials and product, and market your services and goods. But hobbies require expenses, too. Because of that fine line, the IRS uses the amount of time you have been making money pursuing your particular hobby (or business) as one factor to distinguish one from the other. By tax standards, a business will have realized some kind of profit in three of the past five years, including the current year. A hobby might generate a profit periodically, but by tax definition, it is not something you do for the sole purpose of making money, and does not produce consistent profit. If it does? Congratulations. You own a (profitable) business!
What is your intent? If your ultimate goal in your hobby is to turn it into a business, you’ll likely take steps to establish it as its own recognizable entity. The IRS subscribes to the same theory. It considers factors that indicate you’re conducting your side gig in a “businesslike manner.” This might include giving your hobby an official name, creating a business structure for it, applying for a business tax EIN, and/or establishing a business bank account. The IRS will also look for operational changes you have made to enhance profitability, too, like advertising, or accepting credit cards. These actions essentially signal that your intent is to make money; you must adhere to the tax laws pertaining to small businesses.
The differences in deductions. Both hobbyists and business owners can deduct “ordinary” and “necessary” expenses in regards to hobby/business activities. But hobbyists can deduct only up to the amount they have made in income—even if that ultimately means personal loss results for the difference. Businesses, on the other hand, can deduct business-related expenses less income, along with losses from total income. In other words, a business may be eligible to take a bigger (legal) deduction, and potentially, to carryover losses from previous years over, too.
Both hobbyists and businesses must itemize in order to claim their expenses. Regardless of if you determine that you own a business or a hobby, it’s important to keep copious records of the legitimate expenses and losses you claim.
