A Hobby or a Business?

When a habit begins to cost money, it’s called a hobby.—Jewish proverb

It’s great to have a hobby. It’s also great to have a business. And proverbs aside, either one can cost money or make money. But once you get to the point of declaring it at tax time, you have to choose—are you pursuing a hobby, or running a business?

You won’t be surprised to hear that the IRS has very particular ideas about where to draw the line between a hobby and a business. It’s all about your motive—specifically the profit motive. 

Your motive for pursuing a hobby is self-satisfaction. You do it because you enjoy it. You may or may not earn a profit, but that’s secondary. In order to be treated as running a business for IRS purposes—to deduct your business expenses, set up a retirement plan, and claim other tax breaks allowed to business owners—you must be engaged in a “trade or business.” And for that, a profit motive must be present. You might find your business immensely satisfying—goodness, let’s hope so—but the profit motive is non-negotiable.

This doesn’t mean you necessarily make a profit. Many small businesses spend some time marinating in red ink before that happens. But the intention to make a profit is what separates a business from a hobby.

If Uncle Sam considers your business to be a hobby, your ability to deduct losses will be limited to the extent of the income produced by that hobby. This prevents business owners from using a hobby to generate a tax loss to shelter their other income.

Yes, they’ve thought of everything.

All hobby income is reported as “other income” on Line 21 of your Form 1040. Hobby expenses, though, are only deductible if you itemize your deductions. What’s more, they are considered “miscellaneous itemized deductions” and you can only deduct the portion of them.

Although the IRS can challenge any business as a hobby, businesses that have traditionally fallen into the hobby category—”hobby farming,” for example, or home-based craft businesses—face a greater chance of IRS scrutiny than other types.

Establishing a profit motive:

• You may qualify for a presumption that you had a profit motive.
• Or, you can establish the profit motive of your business under the nine factors used by the IRS.
• Hobby loss rules kick in if you are unable to prove that you’re engaged in a business activity under either of these two methods.