income, your tax return — June 10, 2013

Is Your Hobby a Business to the IRS? Part 2

by Bob Williams

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hobby income

You’ll remember, last time we looked at IRS Code Section 183, and how it limited the deductions you can claim for a hobby. And in that case, a hobby is an activity you engage in, but isn’t expected to generate a profit.

That income should be reported, of course, on Form 1040 under Line 21, Other Income. But hobby deductions are very limited. To claim more than the deductions allowed under IRC 183, your hobby would have to be considered a for-profit endeavor. In other words: a business.

Business or Hobby?

The IRS has come up with a list of factors that could be used to determine whether your pastime is more business than hobby. No one factor is decisive. The IRS says all facts and circumstances are taken into account in respect to the activity. The most common factors that should be considered:

  • Do you carry on the activity in a businesslike manner?
  • Do the time and effort you put into the activity indicate that you intend to make it profitable?
  • Do you depend on the income from the activity for your livelihood?
  • Are your losses due to circumstances beyond your control, or are they normal in the startup phase of your type of business?
  • Do you change your methods of operation in an attempt to improve profitability?
  • Do you, or your advisors, have the knowledge needed to carry on the activity as a successful business? Were you successful in making a profit in similar activities in the past?
  • Does the activity make a profit in some years? If so, how much?
  • Can you expect to make a future profit from the appreciation of the assets used in the activity?

 The IRS assumes that an activity is for-profit if it makes a profit in at least three of the last five tax years, including the current year. (In the case of activities that consist mainly of breeding, showing, training or racing horses, that range is two of the last seven years.)

Just to let you know, however, there’s another side to this hobby thing. Sure, you can take a larger deduction if your hobby is classified as a business. But in that case there are issues on the income side to consider.

Business income should be reported on Form 1040, Schedule C, Profit and Loss from Business, or Schedule C-EZ, Net Profit from Business (Sole Proprietorship). If your activity is seen as a business and its net profit exceeds $400 for the year, you should also prepare a Schedule SE for self-employment taxes.

So as it is with so many things in life, what starts as a casual afternoon in the garage, or in the kitchen, just might turn into something much bigger. Just how big is all up to you.

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