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The Online Advisor - December 1998
Business or hobby? What a tax difference a word makes
The IRS requires you to pay tax on all income that you earn. This includes business income and hobby income.
If you are engaged in a business, you can deduct all of your allowable expenses, even if these expenses exceed the amount of income generated by your business. However, if you are engaged in a hobby, you can only deduct expenses up to the amount of income you earn AND only if you itemize deductions.
Example: Ringo is a drummer and earned $7,500 this year from playing in a band. He also incurred $10,500 in expenses - new drum set, travel, etc. If Ringo is engaged in a business, he can deduct all of his $10,500 expenses. If he is engaged in a hobby, he can only deduct $7,500.
Are you engaged in a business or a hobby?
Sometimes it can be difficult to determine whether your activity is a business or a hobby. To help resolve the controversy, the IRS has developed a three-out-of-five-year test. If your activity shows a net profit for three out of five consecutive years, it is presumed to be a business. Conversely, if your activity shows a net loss for three out of five consecutive years, it is presumed to be a hobby. (In the case of horse-related activities, the test is two out of seven years.)
Overcoming the hobby presumption
If you are engaged in an activity and have net losses in three-out-of-five years, you still may be able to deduct all of your expenses, but you'll have to prove to the IRS that your activity is a bona fide business and not a hobby. The IRS will consider the following factors:
1. Total gross income - The more income generated by the activity, the less likely it will be deemed a hobby. Gross income of $10,000 or less supports a hobby classification.
2. Time devoted to activity - If you devote the majority of your working day (6-8 hours) to the activity, it tends to favor business classification.
3. Personal enjoyment derived - If your activity involves painting, golfing, playing a musical instrument, or a similar endeavor that can be associated with personal enjoyment, the IRS will be more likely to conclude it is a hobby.
4. Bank account and business license - If you maintain a separate checking account and have obtained a state, city, or local business license, this will help prove your activity is a business.
If you need assistance in determining whether your activity is a business or hobby, contact our office. We're here to help you.