Is that side hustle a business or a hobby? Know the difference to avoid issues with the IRS.
You may be planning to start a business after you retire from your 9-to-5 job, but it’s important to know whether your venture is a true profit-making operation or just a hobby.
“It’s always been important to determine whether an activity is a business or a hobby because, by law, hobby income is taxable, but you can’t deduct losses,” said Eric Smith, a spokesman for the Internal Revenue Service.
A lot has changed this tax season, specifically what taxpayers’ can deduct. Changes under the 2017 Tax Cuts and Jobs Act mean knowing the difference between a hobby and a legitimate profit-making enterprise is crucial.
“In the past, you could claim hobby expenses as part of the class of miscellaneous itemized deductions that needed to exceed 2 percent of adjusted gross income,” Smith said. “But that category of deductions was eliminated under tax reform.”
Previously, you could deduct expenses from a hobby up to the income it generated as personal itemized deductions, as long as you met the 2 percent threshold. However, starting in 2018 and up until 2025, this deduction is no longer allowed.
“Typically, the IRS presumes the activity to be a business, rather than a hobby, if a person makes a profit in three out of five years,” Smith said.
There is an exception to this rule. If you’re involved in the breeding, training, showing or racing of horses, you must show a profit in at least two of the last seven tax years, including the current year.
To help steer clear of trouble with the IRS, you’ll find much of what you need to know on this issue in IRS “Publication 535 (2018), Business Expenses.”
“If you consistently use your business as a tax shelter, deducting your losses from your other income year after year, you’ll probably attract the attention of the IRS,” attorney Stephen Fishman wrote for the online legal website Nolo. “Make sure that the IRS will consider your endeavor a real business before you start claiming deductions for the costs of your art projects or toy car collection.”
If audited or questioned by the IRS, you must prove you are trying to run a profitable business.
So is your business really a hobby?
The following questions can help you and the IRS determine whether a venture is a business or a hobby.
— Are you conducting yourself in a businesslike manner?
— Are you maintaining complete and accurate financial records?
— Are you putting in the time it takes to make your business profitable?
— Do you depend on income from the venture for your livelihood?
— Are the losses you’re trying to claim due to circumstances beyond your control?
— Do you have the knowledge and skills that can help your enterprise be successful?
— Have you made money in areas similar to the current activity?
— Has your venture made a profit in some years and if so how much?
“There have been many tax court cases over the years where what are really hobby losses are being claimed as business losses,” Smith said. “But if an activity is truly a business, eligible taxpayers should take advantage of any legitimate deduction or credit the law allows.”
The IRS has online publications and resources available if you’re looking to start a business, even if it’s just a part-time or sideline activity to supplement your retirement income.
Read: Publication 583 “Starting a Business and Keeping Records”
And: Publication 334 “Tax Guide for Small Business”
Here’s the bottom line from the IRS: “If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income.”