Do you possess a skill that can benefit those around you? If so, maybe you’ve thought about using that talent to make money. In any case, would you classify that endeavor as a pastime or a business? When it comes to paying taxes, knowing the difference is crucial.
The Internal Revenue Service distinguishes between businesses and hobbies based on whether or not they are pursued for the purpose of making a profit. But as many business owners know, profit is not guaranteed, especially in the beginning.
Before their firms ever begin to make a profit, many entrepreneurs will part with significant sums of money. They may have to pay for things like legal representation, a logo, initial stock and equipment, the creation of a website, the lease on an office space, insurance, and salaries. Business and personal use have vastly different procedures for deducting these costs.
Learn the ins and outs of the IRS’s hobby loss guidelines if you plan on treating your side hustle like a company and deducting all of your startup costs.
Business Expenses Can Be Deducted
The IRS allows businesses to deduct “ordinary and necessary” costs from their taxable revenue.
Expenses that are considered normal in your sector are ones that are routinely paid for by other business owners in the same field. A merchant on Etsy, for instance, might write off the money they spent on inventory and transport.
In other words, necessary expenses are those that are both beneficial and acceptable for your line of work. Advertising and office costs, within reason, are included. It may cost millions of dollars for an Etsy vendor to advertise in Times Square. Business often incurs advertising costs, but is this particular advertisement essential? An auditor from the IRS probably would not approve.
Hobby vs. Business Deductions
Before the Tax Cuts and Jobs Act of 2017, corporations and hobbyists may deduct the same costs, however the methods in which they reduced taxable income were distinct. Schedule C: Profit or Loss From Business is where a sole proprietorship would detail its business revenue and costs. If the business’s costs exceed its revenues, the sole proprietor might utilize the net loss from Schedule C to reduce the amount of salaries, interest, and dividends that would otherwise be taxed to the business.
A hobbyist’s income is reported on Schedule C, but hobby costs cannot be deducted from hobby income. They would need to use Schedule A’s miscellaneous itemized deductions section to write off hobby costs. If the taxpayer’s miscellaneous itemized costs surpassed 2% of their AGI, the person would be eligible for a deduction (AGI). Also, only the amount of money earned from the pastime might be spent on it. Your pastime must not result in a negative cash flow.
As an example, let’s imagine you have a knack for the oven and are frequently asked to provide sweet treats for gatherings of friends and family. You don’t care about making money off of your baking hobby, so you just charge what it costs you to buy the ingredients.
Over the course of the year, you take in $2,000 in payments but spend $2,500 on food, cooking equipment, packing, and delivery. Since you didn’t set out to make a profit, the extra $500 in costs cannot be deducted this year or carried over to the following. This cash simply vanishes instead.
The requirements for deducting hobby costs become even more stringent under the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA repeals the 2% of AGI deduction threshold for miscellaneous itemized deductions from 2018 through 2026. Although deductions for hobby-related costs are now prohibited, hobbyists are still required to record and pay taxes on all of their income. Yikes.
Every year, plenty of people shell out cash on frivolous pursuits with no plans to transform them into a profitable business. If that describes you, the benefits of your hobby might easily outweigh any negative tax implications. The issue arises when you are lawfully operating a business but the Internal Revenue Service treats it as a hobby.
The IRS may recalculate your tax due under the hobby loss rules if they determine that you have made significant investments in getting your firm off the ground while reporting tax losses each year.
Do You Have a Business or a Hobby?
About $70.9 million in annual underpayments, according to the Treasury Inspector General for Tax Administration, might be attributed to erroneous deduction of hobby costs. Therefore, the IRS is likely to investigate taxpayers who repeatedly report company losses.
The IRS is more likely to classify an endeavor as businesslike if you’ve shown a profit in three of the past five years. On the other hand, the IRS understands that many businesses must endure slow growth periods or economic downturns before they can generate a profit.
Therefore, the following criteria are taken into account by an IRS auditor when determining whether an endeavor is commercial in nature or more of a pastime:
- Do you do the activity in a professional manner?
- Is the amount of time and effort you put into the activity an indication that you aim to make it profitable?
- Do you rely on the activity’s earnings for a living?
- If there are losses, are they the result of factors beyond your control, or did they arise during the inception period of the business?
- Have you altered your business practices in an attempt to increase profitability?
- Do you or your advisers have the knowledge required to run the activity as a profitable business?
- Have you already profited from such activities?
- Is the activity profitable in certain years?
- Can you fairly anticipate to profit from the appreciation of assets employed in the activity in the future?
Always keep in mind that the difficulties of surviving hobby loss will be magnified if your work includes components of personal pleasure or amusement. The equestrian industry, which includes horse breeding, training, exhibiting, and racing, is a great illustration of this. Since they are costly and frequently followed as a hobby by the well-to-do, the IRS takes a keen interest in them.
How to Challenge-Proof Your Company
There are ways to “challenge-proof” your firm if you’re concerned about your business spending being reclassified as hobby expenses and so losing out on significant tax deductions.
- Keep meticulous business books and records.
Don’t forget to keep records of your receipts and a running total of your earnings from this endeavor. You can use a notebook, a simple spreadsheet, or cloud-based accounting software. Simple organization is more important than complexity when it comes to your company’s books.
- Keep separate business bank accounts and credit cards.
It’s preferable for small business owners to create a separate corporate bank account and credit card rather than utilize their personal accounts for company activities. This helps you keep better tabs on your organization’s cash flow and is another point the IRS looks at when assessing whether your endeavor is a legitimate business or a hobby.
- Get Proper Licenses, Permits, or Certifications
Most firms can’t legally conduct their operations without obtaining the necessary paperwork from federal, state, or local authorities. Those needs will change based on the kind of your firm and its location. Visit the website of your state’s Secretary of State or municipal issuing office to learn about the rules in effect in your area.
- Create a business plan and keep it up to date.
While having a business plan isn’t mandatory, it is one of the factors an IRS inspector will look at to determine if your enterprise is being managed as a company or a hobby.
There’s no need to spend months creating market analyses, organizational charts, and financial estimates for a business plan unless you’re seeking investment. All you have to do is lay out some basic assumptions about the company, such as its goals, resources, and costs. As a result, you can evaluate progress, adjust to new circumstances, and pursue your company objectives with greater precision.
After you’ve written your business plan, revisit it at least once a year to assess your progress and incorporate any lessons you’ve learned. Make sure to keep track of any alterations you make as a consequence of your evaluation.
- Develop Industry Expertise
A company leader should either have deep expertise in their field or actively seek it out. Take, as an illustration, the case where you’re considering opening a firm that helps people with their tax returns.
People who create these enterprises typically have some background in accounting, either via formal education or professional experience. To make up for a lack of relevant work or school experience, a potential auditor may look into whether you have completed any tax law courses.
- Keep Track of the Time You Spend Working on Your Business
There is no quick fix for making a business successful. Working on your side business after hours and on the weekends is not uncommon if you have a day job and are dedicated to seeing it succeed.
However, most people engage in their hobbies when they have some free time. Keep track of the time you spend on your side gig in addition to your regular employment. If you’re serious about making a profit, you’ll put in the time and energy necessary to get your business off the ground.
- When necessary, alter your course.
When a company is experiencing financial difficulties, its leaders usually investigate the source of the problem and implement solutions to restore profitability. Keep track of your efforts to make a course correction and boost profits.
Consider your aspirations to enter the field of professional photography. You start out thinking that weddings will be your bread and butter, so you dedicate most of your website to that niche, start a wedding photography blog, and set up shop at a local bridal expo. You quickly come to understand that there is intense competition among local wedding photographers, and that you are not booking nearly enough jobs to make a living.
Do you broaden your services by including photographing weddings and proms? Or you might keep photographing weddings even if you’re losing money every year. If you answered “hobby,” you may have a hard time convincing an Internal Revenue Service auditor that your photography is anything but a pastime.
Taking on the IRS
Don’t assume that the Internal Revenue Service will be able to successfully challenge your business loss deductions if you’ve already taken them. Take into account the latest rulings of the Tax Court.
- Delia v. Commissioner
Amy Delia started her hair braiding business at a Maryland mall in 2004. She had agreed to a five-year lease for her booth, with an automatic renewal clause. In 2009, when the country was in the midst of a financial crisis, her salon’s lease was up for renewal and she decided not to renew it. Delia’s landlord was insistent, and she signed a three-year renewal out of worry for her credit.
Delia worked hard to turn a profit at her beauty parlor. She painted the name of her salon on the side of her van and drove around the area handing out leaflets and advertising the company.
She used to have a separate company bank account, but in 2010 she decided to do away with it in order to save money. She continued to maintain the salon’s income and expenditure spreadsheet as well as any related receipts long after she had closed the business’ bank account.
Delia was an event coordinator by day and a hairstylist by night, so she spent her off-hours and weekends interacting with clients who had scheduled appointments or stopping by.
When her landlord agreed to allow her out of the contract in 2012, she shuttered the salon.
In her eight years of operation, Delia’s salon never turned a profit. She made $325 in 2011 from hair braiding, while she spent $16,131 on rent for her booth and other business expenditures, according to her federal tax return. Delia filed a petition with the Tax Court after the IRS rejected her claim of a loss.
The Internal Revenue Service’s Tax Court agreed with Delia in 2016. The Tax Court was “convinced that she ran her hair-braiding company with a genuine and honest (though too optimistic) intention of turning a profit,” despite the fact that she had lost money for eight consecutive years.
- Nix v. Commissioner
Kimberly Nix’s day job was managing projects. Nix chose to sell cosmetics directly to consumers and employ other sales consultants under her in 2012, despite having none prior expertise in sales. Her decision to become a consultant was influenced by the fact that she would earn a 50% discount on all goods she bought for personal use.
After losing $18,142 in 2012, $45,395 in 2013, and $22,353 in 2014 with her cosmetics business, Nix decided to stop consulting. During that time, she regularly attended consultant meetings, but she ultimately implemented no changes to how she ran her company as a consequence of what she learned there.
She managed the company out of her house and didn’t keep any books. Nix claimed to have maintained a separate company checking account at one point, but she has no records of its opening or closure. Also, she was unable to supply an account number.
Nix never made more than $2,000 in cosmetics consulting money, although she took 27 trips over the relevant time period and claimed substantial travel expenditures. She traveled twenty times to watch her daughter play volleyball, twice to visit her in Europe and Disney World, and twice for sorority events in college.
During an audit of Nix’s tax returns from 2012 to 2014, the IRS invalidated any deductions that went above her income. Nix asked the Tax Court to look into her case, but the court ultimately sided with the IRS.
The Court found no evidence that Nix engaged in the activity with the intent to make a profit, as measured by the IRS’s nine-point test. It arrived at its conclusion by considering the following factors:
- Nix’s consulting work was not conducted in a businesslike way since she lacked a business strategy, did not maintain financial records, and took no measures to manage losses.
- During the years in question, Nix had a full-time employment and did not log the number of hours spent on cosmetics consultancy. She claimed to have spent a significant amount of time acquiring goods, making sales calls, and recruiting new consultants, but she had no evidence to substantiate her assertions. She spent a considerable lot of time traveling, although it was evident that the excursions were at least largely for personal leisure rather than company promotion.
- Nix could not reasonably anticipate her business’s assets to increase in value, given that they consisted only of perishable cosmetics goods.
- The Court held that there were “neighborly and social dimensions” to Nix’s cosmetics consultancy, as well as the numerous excursions to volleyball tournaments, family vacations, and sorority reunions, which provided the activity features of personal enjoyment or recreation.
The Tax Court did not just rule against Nix’s extra deductions, they also slapped him with a 20% accuracy-related penalty.
The time restriction for appealing a defeat to the IRS is rather lengthy. To contest a deduction, you have three years from the later of the date the return was filed or the date the deduction was claimed. If, however, more than 25% of gross revenue is missing from the report, the statute of limitations may be tolled. The IRS can investigate your tax returns for the previous six years if it suspects you of intentionally underreporting your income.
Make sure you’re acting like a business even if your side gig is losing money. If the IRS decides to question your deductions, you may avoid a large tax payment, fines, and a lot of hassle by showing that you made an attempt to keep track of your finances, increase profitability, and make a profit.