So you set up your own small business… or did you?
You’re certainly working and making money. But you’ve seen some chatter online about the IRS coming after “hobbies posing as businesses.” Now, you’re no longer sure if you have an actual business in the IRS's eyes.
Don’t worry. Here’s what you need to know about how the IRS treats hobbies vs. businesses — and what it means for your taxes.
What is the difference between a hobby and a business?
In the IRS’s eyes, a hobby is something you do for your own enjoyment, while a business is something you do to make a profit.
That’s the one simple factor it considers when deciding how to classify your money-making activity.
The most important question here: Are you making an effort to generate a profit? If so, then you’ve got a business.
Do you always have to be profitable to be considered a business?
No, you don’t have to make a profit every single year you’re in business. You do have to put in time and effort to push your business into profitability.
What happens if your business is considered a hobby?
Let’s say the IRS decides the business you thought you were running is actually a hobby.
Here are three things that will end up happening on your tax return:
You can’t claim any write-offs
Sorry, chief. The current US tax system doesn’t allow you to write off anything you spend on pursuing your hobby.
Compare that to a legitimate business. Whether you’re freelancing for 50 hours a week or driving for DoorDash on weekends only, pursuing a for-profit activity means you get to write off everything you spend on keeping that activity running.
Have a business, but not sure what you can write off? Try the Keeper app, which automatically scans your transactions to find tax deductions for you.
Your hobby income is still taxable
As long as you’re earning more than $400 from your hobby, you’ll still have to report that income when you file taxes. ($400 is also the tax filing threshold for self-employed income from a business.)
On your 1040 return, your hobby earnings go under “Other Income.”
Being taxed on your hobby income without getting to write off your hobby expenses — that sounds like the worst of both worlds. But there is a silver lining to having a hobby, as far as your taxes go.
You don’t have to pay self-employment tax
If you were running a business, your net profit would be taxed an additional 15.3%. But you don’t pay that dreaded self-employment tax on your hobby income.
This means a hobby with no write-offs might even be taxed less than a business with the write-offs.
How does the IRS decide if you have a hobby or a business?
The IRS lays out nine factors used to determine if an activity is a hobby. They’re all very relative, and they apply differently to different businesses.
To be considered a business, you don’t need to pass all — or even a majority — of these tests. But the ones you do pass will need to drive home to the IRS that you mean business.
These factors are indicated in the tax code in IRC 183, and broken down in easier-to-read language in Chapter 1 of IRS Publication 535, which talks about business expenses.
To really bring them to life, let’s look at each of them through the lens of one of the most important professions in the USA: a party clown.
We’ll be comparing two clowns who take very different approaches to their clowning. Jumbles is a hobbyist, while Squeaks treats it like work.
Factor #1: How you handle the activity
The more effort you put into running things legitimately, the more likely it is to be seen as a business.
- Jumbles strolls up to the party whenever they feel like it, paints some faces, and then hounds the parents for their $30 — before grabbing a bag of chips and wandering away
- Squeaks emails out an invoice ahead of time with their hours and services
Factor #2: Your expertise in the field
It pays to know what you’re doing. This isn’t always about having years of experience in the field.
Other ways of proving your experience include consulting with other experts and learning the skills it takes to grow your business.
- Jumbles the Clown found a rainbow wig at a thrift store and called it a day
- Squeaks the Clown studied juggling for a few weeks, asked other clowns about their rates, and even took a course on comedy down at the community center
Factor #3: The time and effort you spend on your activity
You don’t need to be pursuing your business full-time for it to be enough time. But you do need to make a reasonable effort to make that profit.
- Jumbles only has one booking two months from now — their cousin’s kid’s birthday — and they’re okay with that
- When Squeaks isn’t at a party, they’re reviewing their Yelp page, sending out thank-you emails, and creating TikTok videos to promote themselves
Factor #4: Your success at other activities
Your past success doesn’t need to be perfectly relevant to your current activity. But having past experience in turning a profit somewhere gives you a leg up. (There’s an understanding that businesses don’t always start out profitable, so your track record is helpful here.)
- Jumbles has never been a success in anything, and only took up clowning because they were inspired by an episode of The Simpsons.
- Squeaks actually has a degree in music. They were in a successful band for years but quit to pursue their true passion in clowning, which they approach with the same grit and determination
Factor #5: Your history of income (or losses)
Losses happen to all types of businesses. That doesn’t turn them into hobbies overnight.
The IRS will typically look for three years of consecutive business losses before it starts asking if your activity is a business. Having a good track record in prior years helps create the narrative that it isn’t a hobby.
- Jumbles consistently outspends their earnings by about a thousand bucks. One year, they accidentally turned a profit after they appeared in the background of a viral duck video… but that was after eight years of losses in a row.
- Squeaks actually turns a profit most years. But in any year a killer clown movie comes out, all of a sudden there was a lull in their business.
Factor #6: Your relative amount of profits and losses
There are two parts to this factor:
- Looking at the entire narrative of your business’s run
- Considering how you invest in your business
If you have a really good year, you might have the money to make bigger purchases to grow your business. This might put you at the risk of a small loss for a year or two.
The IRS is fine with that. Investing in your business — or having sporadic income because of the industry you’re in — does not make it a hobby.
- Jumbles is usually at a loss of $5,000 — they buy very expensive clown shoes. But they’ll occasionally turn a profit of around $17 for the year, seemingly by accident
- Squeaks normally turns a profit of around $30,000 every year. But in the lull years, the losses were around $1,000
Factor #7: Your financial status
Essentially, the IRS looks at:
- Your disposable income
- How badly you need the money from this activity
The reasoning here: With no need to make a profit, it’s easier to not really want to make a profit.
- Jumbles is married to the CEO of a Fortune 500 company and can just pour countless funds into this clown pit
- Squeaks the Clown relies on their bookings to pay rent — it’s their primary source of income. If they don’t “honk honk” at least once a week, they don’t eat
Factor #8: The amount of pleasure the activity brings you
Jobs with more inherent “fun” attached to them are at greater risk of being labeled hobbies.
In the eyes of the IRS, an activity like that could easily be something you do that happens to make money, rather than something you do with the intention of making money.
- Jumbles is filthy rich and wants nothing more than to be the local “clown about town”. They’d be a clown even if it never made them a dime (which it typically doesn’t)
- Squeaks hates being a clown most days, and really regrets quitting the band. But they’ve invested so much, they have to see it through. After a good cry, Squeaks puts their nose back on and rejoins the party like the professional that they are
Obviously, this is a bit of a joke because of the profession I chose. But the general principle holds true.
Factor #9: The expectation that your business assets appreciate in value
I’ll be honest: this one is a bit difficult to illustrate with a clown — or with most freelance jobs. Most freelancers just don’t have big, appreciable assets like factory equipment.
The basic idea here: While you’re not necessarily making a profit every year, you’re working in the background to accumulate a potential profit when you eventually sell your assets down the line.
- Jumbles is doing… nothing in particular
- Squeaks records their shows to build an online portfolio of clown content. The videos can be streamed for a small fee without them having to do anything. And they can sell their platform someday to an entertainment company that’s really into clowns
Given all these differences between their clowning activities, Squeaks is more likely than Jumbles to be considered a legitimate businessclown.
How to avoid getting your business classified as a hobby
You know your business better than anyone. Should the IRS come knocking, you want to be prepared.
Make sure you do the following to keep your business on the up-and-up:
Have a written business plan
This should detail what you plan to do over the next three years to grow your business and get — or stay — profitable.
Keep clear records of your business activities
This includes things like:
- Tax records, which you can generate using Keeper
- Records of research you conducted for your business
- Records of certificates and licenses you earned to keep your business strong
Make changes when necessary
The IRS knows not everyone is successful right off the bat.
That’s why its standard for “trying to make a profit” doesn’t just mean bringing in income. It’s also about recognizing why things aren’t working — and changing up your business to make it profitable.
Get help when you need
Not everyone knows everything about the business side of things.
Keeper offers free tools and resources for freelancers who might not know how to keep up with their expenses or file their taxes.
What to do if the IRS decides your business is a hobby
First of all, this isn’t super common — the IRS doesn’t go around targeting side hustlers by declaring that their businesses are actually hobbies. If this does happen to someone, it’ll likely be after an audit triggered for some other reason.
If the IRS rules that your business is a hobby, you aren’t going to be blindsided by this decision. You'll first:
- Be contacted via mail
- Go through some level of audit (either in person or by sending in your documentation)
Here’s what to do if you hear from them:
Appeal the IRS’s decision
If you don’t agree with the IRS’s decision, you can file an appeal to have it reviewed by the IRS appeals division.
Why is it worth appealing?
If your business is considered a hobby one year, the IRS can:
- Go to any other return you filed in the last three years with that same business
- Treat it as a hobby there as well
Note: Appeals can be a long and daunting process. If you end up in that situation, it may be best to consult a tax professional.
File Form 5213
You can file Form 5213, “Election to Postpone Determination as To Whether the Presumption Applies That an Activity is Engaged in for Profit” — quite a mouthful. This form delays the IRS’s final decision until after your fifth year in business.
When can you file the form?
You can file if, within the first few years, you can already see you’re going to struggle to be profitable until year six or seven.
Should you file this form just in case?
No, there’s no need to file when you’re first starting out, “just in case.”
Why? The form will ask for a pretty detailed explanation for why you’re filling it out. If you don’t have enough evidence behind your claim, the IRS will throw it out — and you need some time in business to get that evidence.
Note: You won’t get in trouble for filing Form 5213 only to get it thrown out. But it also isn’t worth your time.
When is the form actually due?
You’ll have to file the form within three years of the original due date for the return you submitted for your first year in business.
So if the first return with your business was due on April 15, 2020, your Form 5213 is due by April 15, 2023.
Remember: A hobby can be turned into a successful business with a bit of elbow grease and the right knowledge. Now that you know the difference between a hobby and a business, you can easily make that change.
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