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Understanding the Tax Rules Surrounding Businesses and Hobbies

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With so many Americans stuck at home with nothing to do during the pandemic, new hobbies became quite popular. In fact, more than half of American adults took on a new hobby during COVID-19, according to a report from LendingTree.

The study found that nearly half (48 percent) of consumers who tried out a new hobby during the pandemic — such as photography, sewing, and baking — earned money by turning it into a side hustle. Of those who made money from their hobby, most used the cash to either pay off debt (52 percent) or save (51 percent). And 79 percent of consumers said they plan to continue their hobby—even after the pandemic comes to an end.

For those individuals who plan to continue their hobby as a side hustle, it is very important to be aware of the rules surrounding taxation for hobbies and businesses. Simply put, the IRS does not think of a hobby and a business as the same thing. Instead, the IRS considers a business to be an activity where the owner intends to make a profit, and a hobby to be an individual’s side project, which happens to earn money. According to Internal Revenue Code Section 183, if your activity earned a profit in three of the past five years, it may be considered a business.

In addition, hobby businesses are often run from one’s home and are based on recreational activities that are close to the home, such as refinishing antiques or breeding dogs. And because your hobby business is something you do purely for fun, and not for money, you should have a full-time job, a second business, or live with a partner who earns some type of income.

To help taxpayers determine whether an activity is a hobby or a business, the IRS developed the following nine-point test:

1. Do you treat the activity like a business by maintaining accounting records?

2. Do you put in the time and effort appropriate to earn a profit?

3. Do you depend on the activity’s income for your livelihood?

4. Are the losses sustained in the activity beyond your control? Did the losses happen during the activity’s startup phase?

5. Have you changed your operations to try to achieve or improve profitability?

6. Do you or your business advisors have the knowledge to run a successful business?

7. Have you profited from running similar businesses in the past?

8. Has the activity ever made a profit and, if so, how much?

9. Can you reasonably expect the activity to earn a profit from the appreciation of assets used in the activity?

These questions were developed to help individuals differentiate between running an activity like a business or as a way to earn extra income. If you answer “yes” to all of these questions, your activity is probably a business. And because businesses and hobbies follow different tax rules, it is vital to understand exactly how they differ. Let’s take a closer look at some frequently asked questions about hobbies versus businesses:

What is the difference between a hobby and a business? According to the IRS, a business operates in order to make a profit. And individuals pursue a hobby for sport or recreation—not to make a profit.

What is the best way to differentiate between hobby income and business income? It is important to keep your business operations separate from your hobbies. Instead of keeping your finances in one account, consider creating separate business bank accounts. Think about creating LLCs to protect your personal assets from company debts and always keep up-to-date accounting records. This will be valuable when it comes time for your tax return.

Can you take tax deductions for your hobby? Under current IRS rules, you can’t deduct any hobby expenses, and you are responsible for reporting and paying income taxes on hobby income. A legitimate business is allowed to deduct its expenses and take a loss—if it is not profitable. However, if the IRS thinks of your activity as a hobby, you are not able to deduct expenses to get a loss to offset other income.

While hobbyists used to be able to deduct expenses up to the amount of their hobby income, this is no longer allowed. Beginning in 2018, the Tax Cuts and Jobs Act eradicated a hobbyists’ ability to deduct non-business expenses as miscellaneous expenses on Schedule A of Form 1040.

Are there certain types of income that are scrutinized closely by the IRS? There are some kinds of income that are likely to be hobbies, and as a result, are more likely to be examined by the IRS. These include dog breeding, photography, writing, making crafts, fishing, and horse racing.

Are there specific audit triggers for the IRS?

The IRS only audits when it is actually concerned about an activity. Triggers can include the following: if the activity incurs a lot of expenses with little income, if losses are used to offset other income, or if the activity generates a large taxpayer benefit.

If your hobby has now turned into an excelling small business reach out to one of our business specialist and set up your LLC so you can continue to thrive. We’re here to answer your questions and  Form your free LLC today! 

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