INTEREST

Hobby vs. Business Expenses

It is important to determine whether your activity is a hobby or a business.This can be a complicated matter, as often sole proprietorsslowly build their businesses over an extended period of time or pursue a longstanding passion that has brought in some money. The distinction between business and hobby is generally made based on how much profit your activity generates and is important to consider because business expenses are generally fully deductible, while deductions for hobby expenses will usually be limited.

ARTIST

Dale is a construction worker with a 9-5 job. For the past two years, on the weekends, he crafts custom furniture that he sells on Etsy. To date, Dale has only managed to break even on his furniture. Since Dale has not generated a profit, he uses the nine factors defined by the IRS to determine if he is engaged in a business or a hobby. He determined that since he does not depend on the income from his activity and only works a few hours per week making furniture, this activity would be considered a hobby, partially deductible on his Schedule A.

ENTREPRENEUR

Paul is a full time college student studying information technology at the University of Wisconsin. To gain experience and set himself up for when he graduates, he spends approximately 20 hours per week making websites for local Madison businesses. Paul makes money on the projects he charges for, however, he also does many projects for free and overall he has not yet turned a profit. Even though Paul's activity is not yet profitable, since he has the skills to make a successful web design business, conducts his activity in a professional manner, puts a significant amount of time into his activity (considering he is a student) and intends to pursue this full time when he graduates, he could likely consider his activity a business and report all of his revenues and expenses on his Schedule C.

ENTREPRENEUR

Two years ago Adina quit her job as a welder so she could pursue her passion, building custom bicycles. She has not yet made a profit but she puts all of her time effort into building bicycles, her livelihood depends on this activity and she does all she can to improve the profitability of her operation. Even though Adina is not profitable, her activity likely meets enough of the IRS factors to be considered a business.

PROFESSIONAL SERVICES

Ling is a retired CPA from Palm Beach, Florida who for the last five years has spent 6 hours per week tutoring accounting. Ling teaches accounting to keep busy, not because she wants to make a profit. However, given the nature of her activity she has made money from tutoring for four of the last five years. Since her activity meets the three of five years test, her tutoring would be considered a business and her expenses would be fully deductible on her Schedule C.

HOW TO KNOW IF YOUR GIG IS A HOBBY OR BUSINESS

  • Typically, the IRS will consider your activity a hobby if you are not trying to make a profit, whereas it would consider your activity a business if you are trying to profit. While this may seem like an easy distinction to make, for some part-timers it may not be so black and white.
  • Generally, your activity would be considered a business if your income from the activity exceeds your related deductions for at least three out of five consecutive years.
  • If your activity does not meet the three of five years test, you still may be able to consider your activity a business if some or all of the following apply (these are just a few of the criteria, refer to our diagram for a complete list): Does the amount of time you spend indicate you are trying to make a profit? Do you depend on income from the activity? Do you conduct the activity in a professional manner? Do you have the knowledge to make it a successful business? Have you been successful in the past making a profit from similar activities?
  • If your activity is classified as a business your revenues and expenses will be reported on your Schedule C. If your activity is classified as a hobby your income from the activity (if any) should be reported on line 21 of your Form 1040 while your expenses (limited to your gross income from the activity) should be reported on line 23 of your Schedule A (if you itemize), and will be deductible subject to the 2% of AGI floor. Also, note that you must deduct your hobby expenses in a specific order until you reach your gross income limit, starting with deductions you could take for personal and business activities (mortgage interest, taxes, etc.), followed by regular business deductions (advertising, utilities, etc.), and lastly by deductions related to property (depreciation, amortization, etc.).
  • If your activity is considered a business you will be subject to self employment tax, however, if it is considered a hobby you will not have to pay self employment tax on the income from your activity.

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