Many of us enjoy hobbies in our free time. Whether its crafting or woodworking, building websites or small engine repair, hobbies offer a respite from everyday life in the form of stress relief and building personal skills.
Sometimes, hobbies can grow into something bigger. Hobby activities can turn out to be a lucrative business venture. Many people have been able to quit their full-time jobs and wholly support themselves doing something that originally began as a hobby.
If your hobby has grown into a full business venture, you might be able to legally deduct expenses for such things as supplies, equipment, office space rental and more. The determination of whether or not something is a hobby or a business, however, is an important one. Unless your venture qualifies as a legitimate business, taking deductions could be hugely detrimental, resulting in underpayment of taxes, IRS collection actions, audits or even criminal implications.
Thankfully, you don’t have to make the determination of hobby-versus-business on your own, in a vacuum. There are factors and IRS/Treasury Department regulations and guidance to help.
- If an activity turns a profit (wherein income exceeds deductions) for three out of five years, there is a presumption that it is a for-profit business instead of simply a hobby
But, not being able to consistently profit from a venture doesn’t mean that it isn’t a legitimate business. Many companies are unable to generate income-over-expenses for their first several years, if they ever do. The factors that the IRS uses to make the determination of whether something is a hobby or a business are:
- Overall financial situation of the taxpayer involved – If the person has significant income from other businesses or activities, it could indicate a desire to use the presumptive hobby as a way to increase deductions and lower overall tax liability.
- Whether the motive in starting the venture was purely personal – A purely personal motive (stress relief, distraction, personal development) that doesn’t revolve around profit generation tips the scales in favor of a hobby instead of a business.
- The success or failure of any prior related activities – Was the taxpayer able to turn a profit with a hobby in the past such that it could be labeled a business? That could indicate that this venture should be treated the same.
- The history of income versus expenses of the hobby activity – Most businesses go through a period where costs outpace income for a time, but being able to eventually profit (more than just occasionally) indicates that the activity is no longer just a hobby.
- The presence of meticulous record-keeping, bookkeeping, employment records, etc.
- The assumption that any assets purchased in pursuit of the venture will appreciate in value.
- Taxpayer’s expertise in the field – Did the person buy proper supplies, fulfill orders, follow accepted industry practices or consult with an expert? If so, that indicates a legitimate business interest instead of a hobby.
- How much time and effort is expended? If someone devotes a significant time, particularly if the taxpayer left his or her full-time job in order to spend more time on the hobby activity, that indicates a desire to run a business.