Business: An activity pursued with the objective to make a profit
Hobby: A revenue producing activity pursued for pleasure and lacking a profit motive
In your eyes which type of activity is yours?
How is each treated for tax purposes?
If you have a business, you are allowed to offset your revenue with all ordinary and necessary business expenses. Should you experience a loss, you can offset other income. A profit is subject to income tax and self-employment tax. In addition, certain other tax benefits may apply.
All income is reportable and only the direct cost in any product sold is an allowable expense. Hobby income is not subject to self-employment tax. Activities such as the sale of your arts/crafts or activities for sport or recreation are often not entered into for profit.
If the activity is reported as a business and experiences several years of loss, IRS may audit you to determine if you have a profit motive. If the loss is disallowed you will owe tax, interest and penalties. Here are several factors they take into consideration.
Among the factors to consider are whether:
- You carry on the activity in a businesslike manner,
- The time and effort you put into the activity indicate you intend to make it profitable,
- You depend on the income for your livelihood. Your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business)
- You change your methods of operation in an attempt to improve profitability,
- You were successful in making a profit in similar activities in the past, The activity makes a profit in some years,
- You can expect to make a future profit from the appreciation of the assets used in the activity.
Some suggestions to prove your profit motivation:
- Keep thorough and businesslike books.
- Log your daily hours spent on the activity
- Use a separate business checking and credit card
- Record business and personal use of assets in a log book
- Research market/technology trends used in similar businesses
- Obtain the insurance, registration, certification, license, etc needed for the business
- Document periodic evaluations of operations to attempt to improve business’s profitability
- Develop a written business plan and update it annually
Regardless of how you would like to treat your activity for tax purposes, will you be able to argue your position with the IRS?