By: Christian Wolgemuth
We all have hobbies – things we do for pleasure during what little free time we have in our lives. Examples are playing music, raising animals, woodworking, and gardening. Sometimes those hobbies even have the potential to make a little extra money for us, like getting paid to play at a concert or by selling a piece of handmade furniture. As we invest more of our personal time and money into our hobbies, they may start to look more like small businesses. This matters because if your hobby is an activity engaged in for profit, you can deduct the costs and expenses you incur from your taxable income.
The IRS provides nine factors to consider when distinguishing between a hobby and a legitimate small business with a for-profit motive. As we go through each of those factors below, keep in mind that they are evaluated objectively and that no factor, in particular, is given any more weight than another.
whether you carry on the activity in a “businesslike manner”
Operating in a “businesslike manner” means you adhere to additional formalities and take extra steps that you would not necessarily do if you were just engaged in a hobby. For example, keeping accurate written records, creating an entity like a limited liability company (LLC), and adopting more efficient techniques and methods can all show a for-profit motive.
whether the time and effort you put into the activity indicate that you intend to make it profitable
Simply put, the more time you devote to the activity, the more likely it is that you are trying to make a profit. That does not necessarily mean you have to quit your current job entirely, but it does mean that a significant portion of your remaining time should be focused on running your new business.
whether you depend on income from the activity for your livelihood
This factor is pretty self-explanatory. If you need this activity or business to put food on the table, then it looks like a for-profit endeavor. On the other hand, if you have substantial income from other sources, then your side hustle may seem more like a recreational hobby.
whether your losses are due to circumstances beyond your control and/or are normal in the startup phase of your type of business
Startup costs that lead to declared losses are typical in many legitimate for-profit businesses. Still, if losses persist beyond the initial startup phase of your business, it may appear like you are not actually trying to earn a profit. The exception to this statement comes in the form of losses that are beyond your control, such as loss from fire, natural disaster, theft, or changes in market conditions.
whether you or your advisors have the knowledge needed to carry on the activity as a successful business
Do you have a very particular set of skills? Skills that you have acquired over a long career?
Having skills and expertise in your field and applying them to your business activity is generally indicative of a profit-making motive. However, even if you do not have those skills yourself, you can seek the guidance and expertise of outside consultants and advisors while trying to make your business profitable.
whether you were successful in making a profit in similar activities in the past
If you have performed the same type of work in a profitable manner in the past, then it is reasonable to say that you are doing it to make a profit now. You are not required to do the exact same activity now as you had done previously; it just has to be similar. Examples of similar activities would be photography and graphic design, or performing music and giving instrument lessons.
whether the activity makes a profit in some years and how much profit it makes
Generally speaking, a legitimate business activity should generate profits more often than it generates losses. The exception to this generality is when profits – although perhaps few and far between – are quite substantial. For example, you may spend years developing a product and incurring expenses all along the way, but when you are finally able to bring that product to market, you achieve a windfall.
whether you can expect to make a future profit from the appreciation of the assets used in the activity
Appreciation in assets includes increases in the value of land and real estate. This means that you can legitimately incur expenses for maintenance and upkeep of property without simultaneously making a profit, so long as you reasonably expect to realize a profit from the disposition of the property in the future.
whether there are strong elements of personal pleasure or recreation
Finally, it should not appear that you are only engaged in the activity for your own personal enjoyment; the profit-making motive should be as strong. This is not to say that we should not enjoy the work we do; I would go so far as to say that we should all be fortunate enough to love our jobs. However, to be a legitimate business, it has to be about more than just personal enjoyment.
Turning your hobby into a legitimate small business can be a great way to earn extra cash and deduct your expenses while doing the things you already love to do. Just remember that if you are going to take advantage of the favorable tax treatment, you must show that you are engaged in an activity for profit.
This post was originally authored on March 18, 2020, and can be found here.
Christian Wolgemuth is a recent graduate of Penn State Dickinson Law. He is currently a Law Clerk at McNees Wallace & Nurick LLC helping clients navigate the continuously changing world of cybersecurity and privacy law.
Sources:
Income & Expenses | Internal Revenue Service – https://www.irs.gov/faqs/small-business-self-employed-other-business/income-expenses/income-expenses
Electronic Code of Federal Regulations. Title 26, Chapter I, Subchapter A, Part 1, §1.183-2 Activity not engaged in for profit defined. https://www.ecfr.gov/cgi-bin/text-idx?SID=2c8c515e70d79f99314ab3dd0c63c6f4&mc=true&node=se26.4.1_1183_62&rgn=div8
Photo Sources:
‘A Very Particular Set of Skills’: Revisiting the Amazing Taken Speech – https://www.esquire.com/entertainment/movies/a31775/taken-speech/
https://www.happify.com/hd/how-to-find-time-to-pursue-a-hobby-you-are-passionate-about/
