Hobby vs. Business Taxation
If you earn money from an activity, you need to figure out if it’s a hobby or a business. This is important because it affects how you report income and whether you can deduct expenses on your tax return. The IRS uses specific tax laws—mainly Internal Revenue Code (IRC) Sections 162 and 183—to make this determination.
What's the Difference Between a Hobby and a Business?
A business, according to IRC § 162, is an activity you run with the intent to make a profit. You work regularly, keep good records, market your services, and expect that over time you will earn income. Businesses can deduct "ordinary and necessary" expenses, and if your business operates at a loss, you may be able to use those losses to reduce your taxable income.
A hobby, on the other hand, is something you do mainly for personal enjoyment, even if it happens to make some money. Common examples include crafting, photography, or baking as a side activity. Under IRC § 183 (the Hobby Loss Rule), hobby income is always taxable, but since the 2018 tax law changes, you cannot deduct any hobby-related expenses.
How Does the IRS Decide If It's a Hobby or Business?
The IRS looks at several factors, including:
Do you run the activity in a businesslike way, keeping records and accounts?
Do you depend on the income for your living?
Are you putting in time and effort to make it profitable?
Have you made a profit in similar activities in the past?
Does the activity make a profit in at least three of the last five years?
No single factor decides the case, but the more your activity looks and operates like a real business, the better your chances of having it classified as one.
Example of a Hobby:
Sarah makes candles on weekends and sells a few online, earning $2,000 in a year. She spends $1,200 on supplies.
She must report the $2,000 as income under IRC § 61.
She cannot deduct the $1,200 in expenses because it’s considered a hobby under IRC § 183.
Example of a Business:
John runs a photography side hustle, advertises his services, and works to get regular clients. He earns $10,000 and spends $6,000 on equipment and marketing.
He reports the income and expenses on Schedule C.
His taxable profit is $4,000, thanks to deductions allowed under IRC § 162.
Why It Matters
If your activity is classified as a hobby, you’ll pay taxes on the income but get no tax break for the costs involved. If it qualifies as a business, you can deduct legitimate expenses, potentially reduce your taxable income, and possibly benefit from business tax strategies.
Tips to Show You Have a Business
To support your case with the IRS, you should:
Keep detailed financial records.
Advertise and seek new customers.
Open separate bank accounts for the activity.
Have a plan to make the activity profitable.
Adjust your operations to try to improve income.
Final Thoughts
The difference between a hobby and a business comes down to your intent to make a profit and how you operate the activity. If you want the tax advantages of a business, make sure you treat it like one. Otherwise, the IRS may treat your income as hobby income, limiting your ability to deduct expenses.
When in doubt, a tax professional can help you review your situation and guide you on the best path forward.