This is Jean Wetzler. I'm talking with Monica Baker from the Small Business/Self-Employed division about determining whether an activity is a business or a hobby.
Monica, how does a taxpayer know if their hobby has turned into a business?
Many a business starts out as a hobby and then turns into a profitable activity. An activity may continue to be a hobby after it produces taxable income if you pursue it without expecting to make a taxable profit. But, if you reasonably expect to earn a profit; you have more than a hobby, you have a business.
What are the tax implications for a business versus a hobby?
Income from an activity is taxable, whether the activity is a hobby or a business. The good news is that you can deduct expenses up to the amount of the hobby income you earn. You can't claim a loss from the hobby. Taxpayers who incorrectly report losses from hobby activities can be subject to additional taxes, interest and penalties in an audit.
What does the IRS consider when deciding if something is a business or a hobby?
The IRS presumes an activity is a business if it makes a profit during at least three of the last five tax years, including the current year. The timeframe is different for breeding, showing, training or racing horses. In those instances, we consider it a hobby if it earns a profit in two of the last seven years. If the profit requirement isn't met, the activity may still be considered a business, depending on certain factors.
Here are a few questions to help you make the correct determination.
Do you spend enough time and effort on the activity to make a profit?
Do you depend on the income for your livelihood?
Have you changed how you operate?
Do you carry on the activity in a businesslike manner?
Do you have the knowledge needed to carry on the activity as a successful business?
How should hobby income and deductions be claimed?
Income earned from a hobby should be reported as other income on Form 1040.
Deductions for hobby activities are claimed as itemized deductions on Schedule A.
Take them in this order and only to this extent. First, take deductions that may be both personal and business related, such as home mortgage interest and taxes, take those in full.
Second, take deductions that don't adjust your basis, such as advertising, insurance premiums and wages. If your gross income for the activity exceeds the deductions you took in the first category, take only the excess here. These expenses are deducted as miscellaneous itemized deductions.
Third, take business deductions that reduce the base of the property, such as depreciation and amortization. Again, take only the amount where your gross income for the activity is more than the deductions you took in the first two categories.
These are also taken as miscellaneous itemized deductions.
What deductions can I take if my hobby has turned into a business?
If an activity qualifies as a business, you may deduct ordinary and necessary expenses. An ordinary expense is one that is common and accepted in that trade or business.
A necessary expense is one that is appropriate for the business. Personal expenses are usually not deductible.
Where can taxpayers get more information?
If you're a new business owner, know your federal tax responsibilities. Visit IRS.gov/smallbiz (with a "z") for help and information.
Thank you, Monica.
I've been talking with Monica Baker of the IRS. This is Jean Wetzler.
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