Question: Is my duck carving a business or a hobby? I donâ€™t want to find I have a tax liability by selling the products of my hobby at local craft fairs.
Answer: If you have a full-time job, are retired or semiretired and have a hobby that results in income-producing activities, you probably have a business and are subject to the rules and regulations of the Internal Revenue Service. Every business idea starts somewhere. Sometimes it starts as a hobby, like bird carving, pottery or quilting.
While keeping your primary job and running a hobby business can be fun and energizing, there are certain tax implications that must be taken into consideration when your business idea is just a hobby.
Is there a difference between a hobby and a business? Block Advisors reports: â€śThe difference is important. A business can offset income with all ordinary and necessary expenses. Businesses can deduct operating losses against other income and even carry the losses forward to offset income in other tax years.â€ť
The bottom line: Itâ€™s usually more difficult to deduct hobby expenses than it is to deduct business expensesÂ â€” and the difference is most notable when expenses are high and losses start mounting up year after year. This is why the IRS pays attention to businesses that have several yearsâ€™ worth of losses. These â€śbusinessesâ€ť may just very well be hobbies.
Your tax liability will be affected depending upon whether your work is classified as an actual business or as a hobby. Here are nine factors, defined by Kayce Hally, from the IRS regulations used to determine if an activity is a business or a hobby:
â€˘ Do you conduct the activity in a businesslike manner? This includes keeping accurate books and records and pursuing operating methods and business techniques with the motive of turning a profit.
â€˘ Do you have expertise in the business?
â€˘ Do you devote much time and effort in carrying on the activity?
â€˘ Are the assets of the activity expected to appreciate in value?
â€˘ Have you had success in starting a new business or converting an unprofitable business into a profitable one?
â€˘ Is the history of income or loss from the activity indicative of a profit motive? If you have continued losses, this may suggest that the activity is a hobby. There is a safe-harbor rule that states if you generate a profit in three out of five years, your activity is deemed a trade or business. For horse racing, breeding, training or showing, the test is two out of the last seven years. The IRS can still disagree, but the burden of proof to show the activity is a hobby versus a trade or business has now shifted from you to them.
â€˘ What is the amount of profit in relation to loss? An occasional small profit in an activity which generates large losses or from an activity in which a large investment has been made would not necessarily translate into a profit motive.
â€˘ Do you have substantial income or capital from other sources? If so, losses from the activity may generate tax benefits by offsetting income from other sources, which is generally not looked kindly upon by the IRS.
â€˘ Does the activity present personal pleasure or recreation? The IRS is more likely to attack an activity that has recreational elements such as racing, horse or dog training or showing, or even weekend farming, rather than tax preparation services.
So what does this mean for you? Any form and amount of income, no matter where it is coming from, is taxable and should be reported. However, hobby activities are reported differently than trade or business activities and have certain limitations. On a positive note, hobby activities are not subject to self-employment tax. However, with changes in the tax regulations, checking with your accountant is prudent when looking at expenses and their tax treatment. Taxpayers who utilize the standard deduction do not receive any benefit from these expenses and those with higher income will also be limited. (Note: Changes to 2018 tax regulations for deductions will also impact itemized deductions.) Additionally, retirement plan contributions, self-employed health insurance and an array of other deductions cannot be used to offset hobby income.
Can you be unprofitable and still be a business? Laura Spencer in Freelance Folder explains the answer: You may think that a string of unprofitable years means that your business will automatically be reclassified as a hobby, but that isnâ€™t necessarily the case. You may still be able to demonstrate that you have an intent to earn a profit even if your business has not earned a profit yet.
To demonstrate a profit motive for your business, first of all make sure that you keep excellent and separate records. It may help your case if you can provide some of the following information:
â€˘ The amount of time you put into the business
â€˘ The percentage of your total income that comes from the business
â€˘ The reason for any losses
â€˘ Changes and improvements youâ€™ve made to the business
â€˘ Evidence of your own knowledge in the field
â€˘ A record of any past business successes including any profits made in earlier years
â€˘ The current and anticipated future value of any business assets
â€˘ Excellent bookkeeping and tax records are the key to your explanation.
The moral of the story: The IRS needs to know about any money youâ€™re bringing in, whether itâ€™s from your daily job, or the hobby app building company you run from your garage. If your business is just a hobby, remember you still need to report it and planning can go a long way in terms of tax benefits and pitfalls.
â€” Contributed by Marc L. Goldberg, certified mentor. This column is not intended to offer legal or accounting advice. If you have specific questions about your tax liability contact your accountant or lawyer. Contact SCORE Cape Cod and the Islands for free free and confidential mentoring at capecod.score.org, firstname.lastname@example.org or 508-775-4884. We go where you are.