How can you distinguish a small business from a hobby and why is this important?

For the IRS an activity is either as a “business” or as a “hobby” and can’t be classified as both. How can you distinguish a small business from a hobby and why is this important to know the difference?

2020 was a year in which many of us, due to the lockdown, layoffs, or the economic crisis caused by the pandemic, had to find new ways to generate income. If you made money doing something you love to do, how can you know when your hobby has turned into a small business and how does this affect your tax obligations?

 

According to the IRS, to know the difference between a hobby or business activity, you must take into account all facts and circumstances with respect to the activity.

A hobby activity is an activity not done for profit. This includes activities done mainly for sport, recreation, or pleasure. No one factor alone is decisive. You must generally consider these factors in determining whether an activity is a business engaged in making a profit:

• Whether you carry on the activity in a businesslike manner and maintain complete and accurate books and records.
• Whether you have personal motives in carrying on the activity.
• Whether the time and effort you put into the activity indicate you intend to make it profitable.
• Whether you depend on income from the activity for your livelihood.
• Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
• Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
• Whether you were successful in making a profit in similar activities in the past.
• Whether the activity makes a profit in some years and how much profit it makes.
• Whether you can expect to make a future profit from the appreciation of the assets used in the activity.

The IRS states clearly that once you make $400 you have to pay self-employment taxes on your side gig. This means that if you have earned more than $400 you must pay federal income taxes and a 15.3% self-employment tax on that income.

 

But though you do have to pay tax on a hobby even if the profit is small, expenses are allowed as deductions only on businesses, not on hobbies, even if you earned money from your hobby.

Previously, a taxpayer could deduct expenses related to a hobby up to the amount of hobby income, but now any expenses related to a hobby are no longer allowed to be deducted. That is why it is important to know the difference.

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