The difference between having a hobby and running a business can be confusing. However, the difference is important because the IRS treats hobbies and businesses differently.
Trade or business. Generally, a trade or business is an activity carried on for a livelihood or in good faith to make a profit. Whether an activity is a trade or business depends on each situation’s facts and circumstances.
Some of the facts and circumstances used to determine if an activity is a trade or business include:
- regularity of the activities,
- regularity of the transactions,
- production of income, and
- ongoing efforts to further the interests of the business.
Part-time trade or business. The client doesn’t have to carry on an activity full-time to have a trade or business. A taxpayer with a part-time trade or business, in addition to a job that pays wages, may be self-employed.
Hobby. A hobby is an activity or interest pursued for pleasure or relaxation and not as an income producing occupation.
Deciding factors. There are a few factors to consider when deciding whether a client has a hobby or a business. The factor that differentiates a hobby from a trade or business is the client’s intent to operate the activity to make a profit or for pleasure or recreation. Some of the other factors to consider when deciding if the client’s activity is a hobby or a business are:
Is the activity conducted like a business?
- Does the client carry out the activity in a businesslike manner?
- Does the taxpayer operate the activity like other similar profitable activities?
- Does the client keep complete and accurate books and records?
- Has the client made, or do they expect to make a profit?
- Has the client engaged in similar activities in the past and converted them from unprofitable to profitable enterprises?
- Does the client intend to profit from appreciation in the value of assets, such as land, used in the activity?
Is the activity profitable in some years?
- Does the taxpayer occasionally have a small profit from the activities that is offset by large investments they have made or suffering large losses?
- Has the taxpayer made substantial profit from the activity?
- Could the activity earn a substantial ultimate profit in a highly speculative venture?
- Can the client expect to make a future profit from the appreciation of the assets used in the activity?
- Does the client have another source of income that could be offset by any losses?
Note. Losses in the startup phase of a business won’t preclude the taxpayer from showing they are operating the activity with the intent to make a profit.
Is the activity the main source of income for the taxpayer?
- Does the taxpayer spend much of their personal time and effort on the activity, particularly if the activity does not have personal or recreational aspects?
- Has the taxpayer pursued the activity full-time or part-time?
- Does the client depend on income from the activity for their livelihood?
Are losses from the activity beyond the taxpayer’s control or are they normal in the startup
phase of their type of business?
- Do the taxpayer’s losses continue beyond the period necessary to bring their activity into profitable status?
- Are the taxpayer’s losses because of things beyond their control, like drought, disease, fire, theft, weather damages, or depressed market conditions?
- Has the taxpayer had a series of years in which they made a profit?
Does the client change their method of operation to improve profitability?
- Does the taxpayer advertise or promote the activity?
- Does the taxpayer work to secure suppliers or products necessary for the activity?
What is the taxpayer and their advisor’s expertise in the activity?
- Does the taxpayer (and their advisors) have the knowledge needed to carry out the activity as a successful business?
- Has the taxpayer (or their advisors) prepared for the activity by extensive study of its accepted business, economic, and scientific practices?
- Does the taxpayer follow the accepted business practices or advice of experts when
they pursue the activity?
Does the activity have elements of personal pleasure or recreation?
- Does the taxpayer have personal motives for doing an activity, especially where there are recreational or personal elements involved?
- Does the activity lack appeal other than profit?
Working through all of these factors with the client will give a practitioner a good handle on the client’s activity and its status for tax purposes. Taxpayers that have a hobby can’t use a loss from that activity to offset other income. However, they can deduct expenses up to the amount of income they receive. The limit on not-for-profit losses applies to individuals,
partnerships, estates, trusts and S corporations. It doesn’t apply to C corporations.
Note. Whether taxpayers have a hobby or run a business, good record keeping is imperative. In addition, whether a taxpayer has a hobby or a business, if they accept more than $600 for goods and services, they could receive a Form 1099-K from their payment processor. Profits from the sale of goods, including personal items, and services is taxable
income that must be reported on tax returns.