For most people, a hobby is simply an activity they enjoy for leisure. They don’t necessarily intend to turn it into a profit-making endeavor. Businesses, on the other hand, operate with the intention of making money, and they must report either a profit or a loss at the end of the tax year. Determining whether your activity qualifies as a business for tax purposes is important when filing your tax return.
Do you have a business or a hobby for tax purposes?
To determine if you have a business or a hobby, ask yourself the following questions:
- Do you keep accurate records?
- Do you intend it to be profitable, and does your time and effort reflect that?
- Do you depend on the income from the activity to survive?
- Do you alter your model to try to make your business more profitable?
- Do you have enough knowledge on the subject to turn it into a business?
- Are your losses a normal part of startup costs, or are they due to circumstances you can’t control?
- Have you made a profit doing a similar activity in the past?
- Was this past profit consistent, or did it see more activity in some years and less in others?
- Do you expect to make a profit from the activity in the future?
Try to answer these questions with facts and be honest with yourself. You probably have a business if you answered ‘yes’ to most of these questions. If you answered ‘no’ to most of them, you probably have a hobby.
If you still need clarification after answering these questions, consider this: If you made a profit in three of the last five years, the IRS considers your activity a for-profit business. This rule extends to two out of the last seven years for activities involving horses, like showing, breeding, and racing.
If your business isn’t profitable and could be at risk of qualifying as a hobby, be sure to keep extensive records and receipts. Make a short-term business plan to try to increase profit. Maintaining these documents is important for your records in case you get audited. Another rule to keep in mind is the Hobby Loss Rule. It states that losses from for-profit endeavors are treated differently than hobbies that may involve some profit.
Do I need a sole proprietorship or LLC for my side business?
If you’ve determined that you have a business instead of a hobby, you don’t need to rush to establish a business entity before filing a tax return. The IRS will automatically tax you as a sole proprietor if you are the only owner.
How much money can you make from a hobby without owing tax?
If you earn more than $400 in a calendar year from your hobby, you should file a return and report it as self-employed income on your taxes. According to the IRS rules, you must file Schedule SE and pay self-employment tax if your net earnings from your activity are $400 or more in a single calendar year. You’ll also be able to deduct certain expenses considered necessary and ordinary for your business.
How to report hobby income
Hobby income is subject to income tax, so you’ll need to report it on your federal income tax return on Form 1040, Schedule 1, Line 8, under the section titled “Other Income.” Hobby income is different from self-employment income, and you aren’t required to pay self-employment tax on the hobby income you report; you only need to report what you earned.
How hobby expense deductions work
If the IRS recognizes your activity as a hobby, you cannot deduct any expenses related to it on your tax return. While this classification can help you avoid self-employment taxes, it means that any related costs (like materials or travel) cannot be subtracted from your taxable income.
Are payments through CashApp or Venmo taxable?
Yes! When calculating net earnings, you must consider transactions made on third-party payment platforms like PayPal and Venmo. If your hobby generates income netting $400 (from all sources), the IRS considers it taxable, and you should report it on your tax return.
In fact, the IRS has plans to require third-party payment platforms to issue Form 1099-K for accounts with more than $5,000 in total transactions related to your hobby or business beginning in 2024. Keep in mind that Form 1099-K will report the gross amount of money you receive.
It does not consider your hobby’s cost of goods sold (COGS). So, when you report the form, you should subtract the cost of the raw materials. However, you cannot access other business expense deductions since you are not operating as a business.
For example, if your hobby is selling baked goods, you could deduct the cost of ingredients. But you could not deduct expenses like the cost of delivering items or fees to be a vendor at a market. Documenting the amount you deduct from your gross earnings is important, just in case you need to reference your deductions in the future.
Note: If you did not receive a 1099-K and you should have or if you have mistakenly received a 1099-K you should contact the app’s support team.
What to do if the IRS classifies your business as a hobby
The IRS may consider your business as a hobby for several reasons. If your business earned a profit in three out of the last five years (including the current year), it’s more likely to be labeled as a legitimate business. If it doesn’t generate profit consistently, the IRS may view it more as a hobby, since hobbies are generally focused more on enjoyment than on making a profit.
The IRS might also classify your business as a hobby if you don’t devote enough time or effort to being a business, if your primary motivation is personal enjoyment, or if you lack a proper business structure.
To ensure the IRS classifies your business correctly, consider taking the following steps:
- Keep thorough records and receipts of all business transactions, including income and expenses.
- Develop a detailed business plan
- Regularly assess your business’s financial performance
- Maintain separate bank accounts for your business and personal finances.
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