Maybe you’re a photographer, or you’re dipping your toes into making and selling jewelry online, but do you know how to account for these expanded interests when tax season comes around? Although we all want to believe that our interests go beyond a “hobby” and should be better classified as a business, it is important to be careful in distinguishing between the two to save you from the headaches of a potential audit.
The 9 Factors that are Indicative of a Business
1. You carry on the business in a businesslike manner
Among other things you should maintain complete and accurate books and may have separate personal and business bank accounts
2. Your time & effort put into the activity indicate an intention to make a profit
3. You depend on the income from this activity
4. Losses are a result of the start-up phase of the business, not circumstances beyond your control
5. You have changed operation methods to improve profitability
6. You have the knowledge and expertise to carry out the activity as a successful business
7. You actually make a profit in some years
8. You can expect to make a profit in the future from the appreciation of assets used in the activity
9. The activity lacks excessive recreational and personal pleasure aspects
What’s the Difference in Tax?
Hobby income must still be reported on your federal income tax return. In years past, hobby expenses could be deducted up to the amount of income earned from that hobby, and only ordinary and necessary expenses may be deducted. For example, if you purchase $1,000 in basket weaving supplies and sell your handmade baskets for $800, you can only write-off $800 of your $1,000 supply cost.
Unfortunately, the 2018 Tax Cuts and Jobs Act has eliminated write-offs for miscellaneous itemized deduction items that under prior law were subject to the 2%-of-AGI deduction threshold. This change discards any deductions from hobby activities. So under the new law, you cannot deduct any hobby-related expenses, but you still must report 100% of any revenue from the hobby activity as income and pay tax on it.
Thus, hobby losses, unlike business losses, cannot be deducted from other income. Business losses may also be carried forward to future tax years whereas hobbies don’t have the same benefit.
Hobby vs. Business Example
Sharon works a full-time job where she makes decent money but has developed an interest outside of this job, painting. When she returns home from her 9-5 she spends her evenings painting with the intent of enjoyment. Eventually, people approach her to purchase her paintings and she begins making a decent profit. Since Sharon did not intend to make a profit in the beginning, and simply painted as a recreation, Sharon cannot claim any losses on her tax return even though she began making a profit. As soon as Sharon takes part in the 9 steps indicated above, and she begins attempting to generate a profit, she would then have a bonafide business and be able to fully deduct her expenses on her tax return beyond her income generated.
What’s the Worst that can Happen?
Claiming a hobby as a business can very possibly trigger an IRS audit. If you are selected for such a fun-time party, you’ll want to produce extensive records and receipts documenting each of the 9 factors above to greatly support your claim of business activity. Other beneficial support includes written business plans, copies of marketing & advertising media, and even possibly support from the best CPA in Atlanta.
If you’re not sure if you have a business or a hobby and want some guidance on how to best satisfy the 9 Factors feel free to contact us for a consultation.