Hobby or Business? Why the IRS Cares, turning a hobby you enjoy into a riioney-making activity can make for an ideal work situation. And many people do turn to their personal interests for business inspiration after they \”retire\” or when they simply want to supplement their job earnings.
The income received from such pursuits is taxable, and legitimate expenses are potentially deductible. But there\’s a hitch- If your activity is deemed to be a hobby rather than a true business, your tax deductions for expenses will be limited under the tax law\’s \”hobby loss\” rules.
Hobby Loss Rules
You may deduct expenses associated with pursuing a hobby, but generally only to the extent of your income from the activity. So, for example, if your total hobby income is $8,000 for the year but your related expenses are $10,000, your $2,000 loss won\’t be deductible. As for the expenses that are deductible – $8,000 in the example those must be claimed as miscellaneous itemized deductions. This restriction may leave you with little or no deduction for your expenses, since miscellaneous expenses of up to 2% of your adjusted gross income are not deductible.
Trade or Business Expenses
These restrictions don\’t apply to a trade or business. If your activity qualifies as a trade or business, ordinary and necessary business expenses will be deductible, even if they exceed your income from the activity. Not only will the expenses reduce your business income, but, if you don\’t turn a profit, you also may deduct the net operating loss, within tax law limits.
It Can Get Tricky
So what constitutes a trade or business tie tax purposes? A trade or business is a pursuit or occupation earned on for profit, whether or not a profit actually results. Profit must be the primary motive, although there may be a secondary nonprofit motive In contrast, a hobby is an activity that is not engaged in for profit The IRS will presume that your activity is carried on for profit and therefore is a bona fide business if it shows a profit in three of the past five years (two out of seven years if your activity consists primarily of breeding, showing, training, or racing horses). If that isn\’t the case, more subjective factors will be considered, such as:
- Your financial status (Do you depend on income from the activity\’?)
- How you conduct the activity
- The amount, of time and effort you put into the activity
- Whether you\’ve been profitable in similar activities
- The expertise of you or your advisors
- The amount of occasional profits (if any) from the activity
- Your history of income or losses from the activity
- Whether you expect to make a profit in the future from the appreciation of assets used in the activity
- The presence of personal pleasure or recreation
Bottom Line If it looks like you are only trying to secure a tax benefit from deducting losses, the chances are good that the IRS will consider your activity a hobby, not a business.
2 Employers: File Form 941, Employer\’s Quarterly Federal Tax Return; quarterly deposit due.
10 Employers: Deferred due date for Form 941, if timely deposits were made.
16 Exempt Organizations: File 2010 Form 990, 990-EZ, or 990-N, if the organization reports on a calendaryear basis.
16 Partnerships and S Corporations: If an election to use a tax year other than a required tax year was made, file Form 8752 to report the required payment.
15 Individuals: Second installment of 2011 estimated tax due; file Form 1040-ES.
15 Corporations: Deposit second installment of estimated income tax for 2011, if the organization reports on a calendar-year basis.