What is the difference between hobby and business when it comes to taxes?
Many wonder, “Is My Business a Business or Hobby?” When it comes to filing your income tax return, you need to know the difference between hobby and business.
The video below shares some things to consider about the difference between hobby and business:
Hobby Loss Rules
Taxpayer View
Taxpayers want everything to be a business if it will help them reduce their taxes.
IRS View
They would rather categorize an entity as a hobby if it is losing money.
- Hobby losses are limited
- Expenses are limited to revenues
- Reported on Sch. A subject to a 2% floor (currently does not apply under TCJA).
Example – Difference Between Hobby and Business for Photography
- You get paid $2,000
- Expenses are $4,000
- You and your spouse’s AGI is $50,000
- You show the $2,000 on your 1040 as other income.
- You are limited to $2,000 in expenses. However, your 2% floor is $1,000 (50,000 x 2% = $1,000). Thus, you only get to deduct $1,000 ($2,000-$1,000 = $1,000).
- And you only get to take that if you itemize!
If it were a business you would get to show a $2000 loss on Schedule C ($2,000 – $4,000 = $2,000 loss).
If it is a hobby, you still have to report the income. However, you might not get to deduct any expenses if you don’t itemize (currently cannot deduct under TCJA). Even if you do, you only get to deduct $2,000 of the expenses.
Difference Between Hobby and Business
If you show a profit 3 out of 5 years, the basic presumption of the IRS is that you are a business.
This is not a hard and fast rule.
Some businesses show losses more than 2 out of 5 years
The basic idea is that if you have a profit motive, you will stop pursuing the business if it continues to show a loss and you do not have a plan to turn things around.
Note: Farms only have to show profits 2 out of 7 years
Profit Motive: The Real Key
It really comes down to do you have a profit motive or is it just a hobby.
Many small businesses do things they love. E.g., photography. But the bottom line is, are you trying to develop it into a successful business?
Other factors in the difference between hobby and business include:
- Time involved
- Are you trying to change your operations to increase profit?
Conclusions and Disclaimer:
Taxpayers generally want to avoid the “hobby” designation.
For a business that continues to show large losses, the IRS may want to re-categorize it as a hobby.
This is a somewhat superficial overview – talk to your tax preparer if you have specific questions or contact us to discuss your specific issues concerning difference between hobby and business.