Be Careful Treating Your Hobby As A Business

Be Careful Treating Your Hobby As A Business

Do you have a hobby that actually makes you some money? Crafting and selling jewelry or pottery for example? Or blogging about travel? Perhaps you help friends breed dogs. Did you know that hobby income is taxable (it should be reported on Form 1040 Schedule 1)? And before 2018 any expenses associated with a hobby were deductible up to the amount of income you received from it (as long as it was more than 2% of your AGI)? Unfortunately, the 2017 Tax Cuts and Jobs Act eliminated the hobby expense deduction but retained the income reporting requirement. Not fair you say? Go complain to Donald Trump. But there is a way to start getting those deductions again. Simply report your hobby as a business. That would allow you not only to reduce taxes on the hobby income but possibly even to deduct hobby losses from your overall taxes. Sound enticing?

Be careful. The key difference between a business and a hobby is that the business is expected to make a profit. The IRS does not appreciate taxpayers pretending their hobbies are businesses just to avoid paying taxes. So before taking such a step be aware of nine factors the IRS will consider in determining whether or not you are operating a truly qualified business.

  1. Do you operate the business in a businesslike manner and maintain complete and accurate books and records?
  2. Can you demonstrate domain expertise in being able to profitably operate such a business?
  3. Do you spend a significant amount of personal time and effort in the business?
  4. Is there an expectation that assets used in the business may appreciate in value?
  5. Have you profitably engaged in similar businesses in the past?
  6. Are losses being incurred beyond the period customarily needed to bring such a business to profitability?
  7. How substantial are the profits as compared to the losses over time?
  8. Are you financially dependent on generating profits from the business?
  9. Do you get some kind of personal pleasure or recreation from the business?

The IRS does not require you to be able to answer every one of these questions satisfactorily in order to prove your business is legitimate. And they understand that losses are common during the early years of a new business startup. But their patience wears thin if the losses drag on for too many years. They are especially unfriendly to taxpayers who, after incurring multiple years of losses without having achieved any profit at all, decide to exit the business. That’s a formula for getting hit with back taxes and possibly even fraud penalties.

If you can figure out a way to turn your hobby into a profitable business, by all means report it as such so that you can take advantage of all the tax deductions you’re legally entitled to. You can use the above questions as a guide to determine if the IRS will buy-in to what you’re doing. But if you do get audited, make sure you’ve got a good supply of Tylenol available.

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