Who doesn’t have a hobby, right? We all need something to do when we aren’t working to help us get through the day. But are you making money from your hobby? The Internal Revenue Service defines a hobby as an activity you pursue without expecting to make a profit. It is something you wish to do because you like it, and the cost of the hobby is not an issue. But if you are making money, the government will want you to pay taxes on your income earned. Home based hobbies or businesses like eBay are popping up all over the place, and it is important to understand the tax ramifications of your hobby.
On your 1040 form Schedule C, you can reduce your taxable hobby income by deducting your hobby expenses, but this tax break is limited. You can only deduct expenses up to the amount of money you make on the hobby. So if you make $5000 per year selling stamps, you are limited to $5000 in total expenses on you r Schedule C, even if you have $10,000 total. If you find you are regularly making money from your hobby, it might be to your tax advantage to turn the hobby into a business, thus allowing you to deduct business losses in the years you don’t turn a profit.
But what constitutes a legitimate business? The IRS uses two tests in determining whether your activity is a business or a hobby. The first test is called the profit test. This means you have to show you earned money on the activity every three out of five years. If I prepare your returns in 2010 and 2011 and you showed a loss from your baseball card collecting hobby/business, than you cannot show a loss on this venture when you file your 2012 tax return.
The 2nd test is the factors-and-circumstance test, and the IRS takes an individual look at your pursuit to determine your status. Are you acting like a business while working on this project? Do you keep accurate books and records, have a website and/or business cards, and can you prove that you have a legitimate going concern and that you have attempted to make a profit? Do you depend on the income from the activity for your livelihood? Are you attempting to change your profitability by adopting different business strategies to try to make more money? How much time do you spend working on this project? The IRS also considers the level of personal pleasure you gain from the hobby/business. It is certainly ok to have fun with the pursuit, but the government does not want to subsidize this personal fun if it is just in fact a hobby.
It is important to understand that the IRS considers ALL the facts above (and then some) in determining whether you have a hobby or a business. If it is your turn to be questioned and the IRS calls your number, be prepared to convince the IRS that you’re making a good-faith attempt to run a business and not just taking extra deductions on your Schedule C so you can show a loss and cut your taxable income, thus lowering your total tax.
Click below to listen to Stu and Win Damon of WNBP FM 106.1 chat about this subject
With more than 23 years of experience as a credentialed tax professional, Stu Steinberg, CPA, MBA brings a broad depth of knowledge to his work. He has worked with families and small business entrepreneurs for many years helping them plan more effectively. He can be reached at stu@erocktax.com or (781) 247-5569 anytime.