It's a wonderful thing if your hobby starts making money, but at what point does it turn into an actual business? The IRS states that it turns into a business when you start trying to earn money. From a tax standpoint, the main difference between a hobby and business is being able to deduct losses.

Shannon works in sales where she makes decent money and lives in a nice house with her family. Shannon doesn’t dislike her job, but it’s not her passion. So every Friday, at the end of a draining 40-hour work week, Shannon hurries home to spend time on something she does love: painting.

Shannon’s a talented artist, and a few people approach her about buying her paintings. Then, they tell some friends, and one day Shannon actually starts to make money selling her art. In the beginning, it’s just enough to cover her supplies, but after several months, she starts to earn a decent profit. Although she never intended it to, Shannon’s hobby has turned into everybody’s dream: a fabulous source of side income.

But here’s the question: Now that she’s making money, is Shannon operating a business or practicing a hobby?

You might think the answer is obvious. She made a profit, so she must be in businesses, right? Actually, you’d be wrong. From the point of view of the Internal Revenue Service, if Shannon isn’t painting with the intent to make money, she’s practicing a hobby.

The IRS defines a hobby as an activity that an individual pursues without intent to generate a profit. Almost everyone partakes in some sort of hobby without worrying about whether it will generate income. However, as soon as you take steps to attempt to generate a profit you’ve got a business on your hands. Of course, that’s not necessarily a bad thing.

Tax Limitations for Hobbies

The biggest tax limitation for a hobby is that you cannot deduct a loss from its activities. Most hobbies come with some sort of expense, be it equipment, supplies, or educational fees. But the IRS says you cannot deduct those expenses beyond the amount of income you generate from your hobby.

For example, in the case of Shannon, her painting supplies (paint, brushes, canvas, paper, etc.) obviously cost money. Before she starts to make money from her paintings, she cannot deduct any of painting expenses on her tax return. When she starts to make money, she can deduct painting expenses—but only up to the amount of income she generates from the art, meaning that she could create a net taxable impact of zero from her hobby. Until Shannon starts to treat her hobby as a business, she won’t be able to claim a loss on her taxes.

How to Convince the IRS It’s a Business

Let’s say Shannon decides that she’s making enough of a profit that she wants to take her art to the next level and turn it into a business. How does she make the change from hobby to business?

Here are nine questions the IRS has provided to determine whether your activity is engaged in for a profit (e.g. a business):

  • Does the time and effort put into the activity indicate an intention to make a profit?
  • Do you depend on income from the activity?
  • If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
  • Have you changed methods of operation to improve profitability?
  • Do you have the knowledge needed to carry on the activity as a successful business?
  • Have you made a profit in similar activities in the past?
  • Does the activity make a profit in some years?
  • Do you expect to make a profit in the future from the appreciation of assets used in the activity?

If your answers to these questions imply that your activity is a business, you can treat it as a business for tax purposes. As I mentioned earlier, the biggest advantage of running a business instead of participating in a hobby is that you can deduct losses against your income for your business.

If your activity does qualify for a business, than you would use Schedule C to claim all income and expenses from your that activity.

If You Don’t Qualify As a Business

If your activity does not pass the test to be treated as a business, then you won’t be able to deduct a loss (if you have one) on your tax return. But that doesn’t mean you don’t have to keep detailed records of all your transactions that result from your hobby.

If you generate income from your hobby, you’ll still have to report that income to the IRS because it’s against the law not to report all income that you earn. It’s important to maintain records of your hobby expenses since you are allowed to deduct expenses up to the amount of income that you generate. There is one catch: You must itemize to claim any expenses for your hobby.

Don’t Let Taxes Deter Your Interests

If you don’t want to mix taxes and pleasure, then simply avoid generating any income from your hobbies. If you don’t receive income from your hobby activities, you won’t be affected by tax laws. Don’t let complicated tax code scare you off from doing what you love.

Do you participate in hobbies and make a profit?

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About the author

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Amber Gilstrap is a twenty-something CPA from Kansas City, Missouri who loves writing, working out, and---of course---finding fresh ideas for saving money.