There are some activities we engage in outside of work strictly for personal reasons, with no thought of ever profiting from them. You might, for example, enjoy photography, hiking on the weekends, or collecting classic records. There is no monetary gain—and no expectation of making a profit—from these pastimes. You do them simply because you like to do them.
Then there are pastimes that we do not consider to be a job or primary income source but that enable us to earn some additional money. Maybe you started taking pictures just for fun and posting them to social media. They attracted some attention and now a few people are booking you to photograph their weddings and take professional headshots for them.
Even though you are making a bit of money on the side, you still think of photography as a hobby, not as a business. The Internal Revenue Service (IRS), however, has its own rules for determining whether an activity is a business or a hobby. Understanding these rules can help you take advantage of tax breaks and avoid adverse action by the IRS.
Business versus Hobby: Factors the IRS Considers
According to the IRS, a hobby is an activity that someone pursues because they enjoy it, without any intention or expectation of making a profit. A business, on the other hand, is operated to make a profit.
How can you tell the difference between the two? Here are the factors the IRS considers:
- Does the time and effort you put into the activity reflect a desire to profit from it?
- Do you keep accurate books and records of the activity?
- Do you depend on income from the activity?
- Were there losses from the activity, and if so, were they beyond your control?
- Have you changed your approach to the activity to increase profitability?
- Do you have the knowledge and skills needed to carry out the activity as a successful business?
- Have you made a profit in the past from similar activities?
- Does the activity make a profit in some years, and if so, how much?
- Can you expect future profit from the appreciation of assets used in the activity?
The IRS notes that all of the facts and circumstances of the activity must be considered, and no one factor is weighted more heavily than the others. An additional factor to keep in mind is that the IRS presumes an activity is carried on for profit—and is therefore a business—if it made a profit during at least three of the last five tax years.
Tax Implications for Hobby Activities
Regardless of whether your activity is a business or a hobby, if it makes any money at all, you must report the income on your tax return. The place to report it is on Schedule 1, Form 1040, line 8. Failure to report income could draw the attention of the IRS, especially if they received a form showing that somebody else paid you to perform work for them.
Unfortunately, while income from hobby activities must be reported, hobbies do not qualify for tax deductions. It was previously possible to itemize deductions for necessary expenses associated with a hobby, but this changed beginning with the 2018 tax year as a result of the Tax Cuts and Jobs Act (TCJA) of 2017. TCJA rules are in effect through 2025.
Tax Implications for Business Activities
If your activity is considered a business and not a hobby, you are allowed to deduct expenses associated with it. Business tax deductions include operating expenses such as home office and office supply costs, work-related travel expenses, phone and internet expenses, legal and professional fees (including fees for working with a tax professional), rent, interest, depreciation, and the costs of advertising and promotion. You can also deduct net losses from the business activity, within certain limits.
Not surprisingly, the IRS has a long list of rules for business deductions. Accuracy is important when writing off business activity, as the IRS commonly flags business expenses for closer inspection. Any inaccuracies could lead to an audit. Make sure you can document any business expenses that you claim.
Not sure if your activity counts as a business or a hobby? Need help addressing this issue on next year’s tax return? Did you start a side hustle in the past year and are not sure how to report this income and pay taxes on it? Has the IRS contacted you about an outstanding reporting issue? Contact our office to speak with a tax law professional.