Do you have a talent that provides value to others? If so, you may have considered turning that skill into a money-making venture. But would that venture be a hobby or a business? For tax purposes, the distinction matters.
According to the IRS, the difference between a business and a hobby is that the goal of a business is to make a profit, while people engage in a hobby for sport or recreation. But as many entrepreneurs know, businesses don’t always turn a profit, especially in the early stages.
Many entrepreneurs spend money before their businesses are up and running. They might have expenses for legal work, logo design, starting inventory and equipment, building a website, renting office space, insurance, and payroll. The rules for deducting these expenses are very different for a business than they are for a hobby.
If you want to treat your side hustle as a business and get the full tax benefit of the money you spend to get it off the ground, you need to familiarize yourself with the IRS’s hobby loss rules.
Deducting Business Expenses
A business can offset its taxable income with “ordinary and necessary” business expenses.
Ordinary expenses are ones that are common and accepted in your industry – in other words, things other businesses owners in your industry typically purchase. For example, an Etsy seller could deduct the cost of buying or producing the products they sell, as well as shipping expenses.
Necessary expenses are ones that are helpful and appropriate for your trade or business – in other words, the costs required for your business to succeed. This includes things like advertising and office expenses, within reason. For example, an Etsy seller could pay millions of dollars to advertise their shop in Times Square. Advertising is an ordinary business expense, but is such an expensive ad necessary? Chances are, an IRS auditor would say no.
Hobby vs. Business Deductions
Before the Tax Cuts and Jobs Act of 2017, hobbies and businesses could deduct the same types of expenses, but these expenses offset income in different ways. A business organized as a sole proprietorship would report its income and expenses on Schedule C: Profit or Loss From Business. If its expenses were greater than its revenues, the net loss from Schedule C could be used to offset the sole proprietor’s other taxable income, such as wages, interest, and dividends.
A hobbyist would also report their income on Schedule C, but they couldn’t net hobby expenses against hobby income. Instead, they would have to claim hobby expenses as miscellaneous itemized deductions on Schedule A. The taxpayer would only receive a deduction if their total miscellaneous itemized expenses exceeded 2% of their adjusted gross income (AGI). Also, hobby expenses were limited to the amount of reported hobby income. In other words, your hobby could not generate a net loss.
To illustrate, say you enjoy baking cupcakes, so your friends and family ask you to bake cupcakes for parties and special events. You’re not interested in turning your passion for baking into profit, so you charge just enough to cover your materials. You receive $2,000 in payments during the year, but between ingredients, kitchen equipment, packaging, and delivery, you spend $2,500. That extra $500 in expenses cannot be deducted or carried forward to next year since your aim wasn’t to earn a profit. Instead, this money simply disappears.
The Tax Cuts and Jobs Act of 2017 (TCJA) made the rules for deducting hobby expenses even worse. From 2018 until 2026, the TCJA eliminates the miscellaneous itemized deductions that were previously subject to the 2% of AGI deduction threshold. Now, taxpayers can’t deduct any hobby-related expenses, but they must still report 100% of their hobby income and pay taxes on it. Yikes.
Plenty of people spend money on their hobbies every year with no intention of turning them into a money-making venture. If that’s you, the pleasure you derive from your pastime may far outweigh the potential tax consequences. The problem occurs when you’re legitimately trying to run a business but the IRS says you’re running a hobby. If you’ve been investing heavily in your business to get it off the ground and reporting tax losses each year, you run the risk of the IRS challenging your deduction and recalculating your tax liability under hobby loss rules.
Are You Running a Business or a Hobby?
The Treasury Inspector General for Tax Administration estimates that the incorrect deduction of hobby expenses accounts for approximately $70.9 million in underpaid taxes each year. As a result, the IRS tends to scrutinize taxpayers who claim losses from a business year after year.
If you’ve made a profit in at least three out of the last five years, the IRS will likely consider the activity to be a business. However, the IRS realizes many companies take time to become profitable or go through downturns. So, when deciding whether an activity is a business or a hobby, an IRS auditor considers a number of factors:
- Do you carry on the activity in a businesslike manner?
- Does the time and effort put into the activity indicate that you intend to make it profitable?
- Do you depend on income from the activity for your livelihood?
- If there are losses, are they due to circumstances beyond your control, or did they occur in the business’s startup phase?
- Have you changed your methods of operation in an attempt to improve profitability?
- Do you or your advisors have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit from similar activities in the past?
- Does the activity make a profit in some years?
- Can you reasonably expect to make a profit in the future from the appreciation of assets used in the activity?
Keep in mind that if your business has elements of personal pleasure or recreation, you’ll have a tougher time overcoming hobby loss challenges. Horse breeding, training, showing, and racing businesses are perfect examples. They attract a lot of IRS attention because they’re expensive and often pursued as a hobby by wealthy individuals.
How to Challenge-Proof Your Business
If you’re worried about your business expenses being reclassified as hobby expenses, causing you to lose out on valuable tax deductions, there are steps you can take to “challenge-proof” your business.
1. Keep Thorough Business Books & Records
Track all your income and expenses from the activity and keep copies of your receipts. You can use cloud-based accounting software, a simple spreadsheet, or even an old-fashioned notebook. Your business accounting doesn’t have to be complicated, but it should be organized.
2. Maintain Separate Business Bank Accounts & Credit Cards
Small business owners sometimes use their personal checking account or credit card for their businesses, but it’s better to open a separate account. Not only does this make it easier to track your business revenues and expenses, but it’s another factor the IRS considers when deciding whether you operate a business or a hobby.
3. Get Proper Licenses, Permits, or Certifications
Most businesses need certain licenses, permits, or certifications from federal, state, or local agencies to operate. The requirements vary depending on your business activities and location. Research your state, county, and city regulations by visiting the website of your Secretary of State or local issuing agency.
4. Write a Business Plan & Update It Regularly
Many small business owners skip creating a business plan, but having a business plan is one of the criteria an IRS auditor will consider when deciding whether you’re running your operation like a business or a hobby.
Unless you’re trying to raise capital, writing a business plan doesn’t have to mean spending months compiling pages and pages of market analysis, organizational charts, and financial projections. You only need to outline your expectations for the business: what the business will do, how much it will cost to do it, and where the money will come from. This helps you measure your performance, adapt to changing market conditions, and stay on track for your business goals.
Once you’ve drafted your business plan, check in on it at least annually to see what went right, what went wrong, and what you’ve learned in the process. Document any changes you make as a result of your review.
5. Develop Industry Expertise
A business owner should have extensive knowledge of the industry they’re operating in or seek advice from experts. For example, say you want to start a tax return preparation business. Most people who start these businesses have an accounting degree or experience working in the industry that gives them the expertise to prepare tax returns for others. If you don’t have any academic or professional background that would give you the necessary knowledge, an auditor might consider whether you’ve taken classes to learn about tax law.
6. Document Time Spent Working on Your Business
Running a profitable business takes time. If you’re passionate about growing your business while working a day job, you may spend hours at it in the evenings and on weekends. Hobbies, on the other hand, are usually carried on during a person’s free time. If you have a full-time job outside of your side hustle, document the amount of time you spend working on your business. The amount of time and effort you devote to getting your business up and running is a good indicator of whether you intend to make a profit.
7. Change Course When Needed
When a business is losing money, its owners typically seek to understand the reasons why and make changes to improve profitability. Document your attempts to change course and improve profitability.
Let’s say you’re working on becoming a professional photographer. At first, you believe wedding photography will be your bread and butter, so you build a website with a heavy focus on wedding photography, blog about weddings, and buy a booth at a local bridal expo. You soon realize there’s a lot of competition among wedding photographers in your area, and you’re not booking the number of weddings you need to be successful.
Do you expand your offerings and start shooting family portraits and corporate events? Or do you continue shooting weddings and losing money year after year? If your answer is the latter, you might have a hard time convincing an IRS auditor your photography is a business and not a hobby.
Challenging the IRS
If you’re worried your business loss deductions won’t stand up to IRS scrutiny, you should know that the IRS isn’t always successful at challenging these deductions. Consider these recent Tax Court outcomes.
1. Delia v. Commissioner
In 2004, Amy Delia opened a hair-braiding salon in a shopping mall near her home in Maryland. She signed a five-year lease for her booth, and the agreement included an automatic renewal at the end of the five-year period. When her lease came up for renewal in 2009, the country was in the middle of a financial crisis, her salon wasn’t doing well, and she didn’t want to renew the lease. However, her landlord insisted, and Delia, fearing damage to her credit score if she refused, signed a three-year renewal.
Delia attempted to make her salon profitable. She took out ads, maintained a website and a business phone line, painted the name of her salon on the side of her van, and handed out advertising fliers in the neighborhood. For a while, she had a separate business bank account, but she closed it in 2010 to reduce her costs. Even after closing the bank account, she kept a spreadsheet showing income and expenses for the salon and kept receipts for her expenses.
Delia worked full-time as an event planner but spent evenings and weekends at the salon, either meeting customers with appointments or hoping to get walk-ins. She closed the salon in 2012 when her landlord let her out of the lease.
Delia never posted a profit from the salon for the eight years she was in business. On her 2011 federal income tax return, she reported income from hair braiding of $325 and expenses of $16,131 – most of which was her rent on the booth lease. The IRS denied the loss, and Delia asked the Tax Court to review her case.
In 2016, the Tax Court sided with Delia. Despite eight years of losses, the Tax Court ruled that they were “convinced that she conducted her hair-braiding business with an actual and honest (if unduly optimistic) objective of making a profit.”
In the ruling, the Court explained its reasoning:
- Delia’s business failed for reasons beyond her control – in other words, the 2008 to 2010 financial crisis.
- Delia kept business records and undertook reasonable marketing efforts.
- Delia may have been fond of hair braiding, but spending hours of her evenings and weekends sitting in an empty booth at a shopping mall wasn’t considered a source of personal pleasure or recreation.
However, taxpayers don’t always win.
2. Nix v. Commissioner
Kimberly Nix was employed full-time as a project manager. In 2012, despite having no prior sales experience, Nix decided to become a network marketing consultant, selling cosmetics directly to consumers and recruiting other sales consultants underneath her. Part of her motivation for becoming a consultant was the 50% discount she would receive on products she purchased for her own use.
Nix reported a loss of $18,142 from her cosmetics business in 2012, a loss of $45,395 from the activity in 2013, and a loss of $22,353 in 2014, after which she ceased consulting. During those years, she attended weekly consultant meetings but didn’t change how she operated her business as a result of anything she learned at those meetings. She ran the business from her home and didn’t maintain any business financial records. Nix said she had a separate business bank account for a time but didn’t have statements or know when she opened or closed the account. She also couldn’t provide an account number.
Although Nix never brought in more than $2,000 of income from cosmetics consulting, she went on 27 separate trips during the three years in question and claimed significant travel expenses for those trips. Twenty of those trips were to her daughter’s volleyball tournaments, two were vacations with her daughter to Europe and Disney World, and two involved meetings with her college sorority.
The IRS examined Nix’s returns for 2012 to 2014 and disallowed any expenses that exceeded her income each year. Nix petitioned the Tax Court to review her case and, perhaps not surprisingly, the Tax Court agreed with the IRS.
Of the nine factors the IRS considers when deciding whether an activity is a business or a hobby, the Court concluded that none of them supported Nix’s contention that she engaged in the activity with the intention of earning a profit. It based its opinion on the following reasoning:
- Nix did not conduct her consulting activity in a businesslike manner because she had no business plan, did not keep financial records, and took no steps to control losses.
- Nix had a full-time job during all of the years in question and didn’t keep records to document the number of hours spent on cosmetics consulting. Although she claimed to have spent considerable time purchasing inventory, making sales calls, and attempting to recruit new consultants, she had nothing to support those claims. She did spend a significant amount of time traveling, but it was apparent the trips were at least partially for personal recreation rather than marketing her business.
- Nix could not reasonably expect that the assets owned by her business would appreciate in value because her only business assets were perishable cosmetics inventory.
- The Court determined there were “neighborly and social aspects” to Nix’s cosmetics consulting – not to mention the many trips to volleyball tournaments, family vacations, and reunions with sorority sisters – that gave the activity elements of personal pleasure or recreation.
Not only did the Tax Court disallow Nix’s excess deductions, but they also imposed a 20% accuracy-related penalty.
The IRS has a long statute of limitations for challenging losses. Typically, deduction challenges can go back three years from the date of the return or the date on which the return was filed, whichever is later. However, the statute of limitations can be extended if there is a substantial omission of more than 25% of the gross reported income. If the IRS believes you’ve substantially underreported your income, it can go back six years.
If you have a side hustle that generates losses, make sure you’re running it in a businesslike manner. Demonstrating your efforts to track your finances, improve profitability, and turn a profit can save you from a hefty tax bill, stiff penalties, and a big headache if the IRS decides to challenge your deductions.
Do you have a side hustle? What steps do you take to run it like a business?