How to tell if a Hobby has risen to the level of a business…

The IRS has created a list of factors and circumstances to determine whether a hobby has risen to the level of a business. We all know whether we are working or performing a hobby, but some are fortunate enough to make it a living. When you are not sure, check the factors and circumstances, and keep in mind a business is operated with intention of making a profit while a hobby is for enjoyment. The distinction for tax purposes between hobby or loss is important because the treatment differs and if there are losses 3 out of 5 years, then the IRS can reclassify the business losses as nondeductible hobby losses.

Hobby income is taxable as ordinary income on schedule 1 while the losses and expenses are nondeductible. The only expense that can be deducted for a hobby would be the cost of the product itself. For example, I purchased a surfboard for $1000 and after some use decide I want a different board. I sell it for $500, which is a loss, that is nondeductible, that is reported on schedule D and form 8949 on my return. No travel expenses, meals, transportation expenses are deductible for surfing as a hobby.

A business which is operated with the intention of making a profit is allowed to deduct ordinary and necessary expenses for the business. Losses are fully deductible and income is subject to an additional self employment tax of 15.3% The taxpayer can deduct self employed health insurance premiums, make deductible contributions to retirement accounts, and is already contributing towards Social security in retirement via the self employment tax. Most businesses do not make a profit initially, hence the 3/5 loss rule allows a 5 year period for taxpayers to maybe cut back on expenses if the business does not pan out.

Many social media posts are claiming outrageous tax advice, if it sounds too good to be true it is. If a hobby is beginning to be substantially profitable or could be, then consider yourself lucky because you will be doing something for enjoyment and a living. The IRS is clear on this issue and is not a grey area, so use your accountant if you have any more questions that need clarification.