At first glance it seems obvious what the difference is between a hobby and a business. But the IRS draws a heavy line between them. Click through for insights into IRS regulations to help you learn when your hobby becomes a profit-making entity.
Is your hobby a business? It matters to the IRS. The agency says your hobby is a business if it operates to make a profit. But it’s not a simple determination. To start with, intent matters.
Here are some factors the IRS offers to help you ascertain whether your hobby is a business:
- You carry out your activity in a businesslike manner and maintain complete and accurate books and records.
- The time and effort you put into the activity shows you intend to make it profitable.
- You depend on income from your activity for your livelihood.
- Your losses are indicative of a business. This is complicated: Losses are normal in a business’s startup phase. Still, this may not necessarily indicate that the activity is not engaged in for profit. If the losses continue beyond a period in which its customary to bring an operation to profit, then this may indicate the activity is not being engaged in for profit.
- You change methods of operation to improve profitability.
- You and your advisers have the knowledge needed to carry out the activity as a successful business.
- You were successful in making a profit in similar activities in the past.
- You can expect to make a future profit from the appreciation of assets used in the activity. The IRS will take into consideration whether you make a profit in some years and, if so, how much.
If the activity you’re engaged in turns a profit, deductions are allowable for money spent for the production or collection of income or for the management, conservation or maintenance of property that brings you income. Deductions aren’t allowable if your activities aren’t turning a profit, including sports or things you do for recreation.
The IRS considers intent
The IRS uses no one factor to make the determination. A lot of the decision hinges on intent to derive profit. But here, too, it’s fuzzy because greater weight is given to objective facts than to your statement of intent, according to the IRS. Here are some scenarios to consider:
- If you attempt to develop new or superior techniques that may result in profit, then we’re talking business.
- How much time you devote to the activity that doesn’t have substantial personal or recreational aspects may indicate your intention to make a profit.
- If you stopped your usual occupation and devote most of your time and energy to another activity, it looks like a business to the IRS.
- If you are employing qualified people to help, even though you are not spending significant time yourself — that looks like a business.
- Assets used in your activity appreciate — even the land used in the activity. Though you point out that there’s no intent to make a profit, if the value of land used increases, exceeding your expenses of operation, then you’ve made a profit.
- Suppose in the past you’ve done a similar activity and took it from an unprofitable to a profitable undertaking. This may indicate that your present activity is for profit, even though it’s presently unprofitable.
- The amount of profit in relation to losses incurred in relation to your investment is important. An occasional small profit coming from an activity that generates large losses or from an activity you’ve made a large investment in wouldn’t generally be an indication that you’re engaged in your activity for profit. However, substantial profit, even occasionally, makes it look like you’re in it for profit. If you don’t seem to have substantial income or capital aside from your activity, that looks like you’re expecting a profit from your so-called hobby.
- If the losses from your activity generate substantial tax benefits, it may show that you’re not so much interested in profit as in using losses on your tax return.
While intent is important in determining whether you’re running a business or enjoying a hobby, the IRS looks at the income derived from the activity. Your lack of a profit objective may seem to indicate you’re engaged in a hobby, but as you can see, many factors are considered in making this determination. The important takeaway here is to work closely with a tax professional.