Hobby or Business? How to Tell the Difference and Why It Matters at Tax Time

When tax season rolls around, many people find themselves wondering whether their passion project should be classified as a hobby or a business. While hobbies and businesses might sometimes look similar, the IRS views them very differently—and this distinction can significantly impact your taxes.

Here’s what you need to know to decide whether your activity is a hobby or a business, and how that determination affects your tax situation.

What’s the Difference Between a Hobby and a Business?

Simply put, the key difference lies in intent: a business is operated primarily to make a profit, while a hobby is pursued mainly for enjoyment or personal fulfillment. This intent significantly impacts how the IRS treats your income and expenses at tax time.

Regardless of whether your activity is classified as a hobby or a business, if you receive payments through third-party payment apps (like Venmo, PayPal, or Square), you might receive IRS Form 1099-K. Any income reported on this form must be included in your federal tax return.

Key Factors to Determine if You’re Running a Business or a Hobby

While the IRS doesn’t rely on a single factor to decide between hobby and business, here are several key questions you should consider carefully:

• Intent for profit: Do you genuinely intend to make a profit, even if you’re not currently profitable?
  
  
• Profitability: Has your activity actually generated profit? If so, how substantial is it?
  
  
• Asset appreciation: Are you expecting your assets related to the activity to appreciate, generating future profit?
  
  
• Dependence on the income: Is this activity your primary source of income, or do you depend on it significantly for your livelihood?
  
  
• Loss analysis: Are any losses a result of circumstances beyond your control (such as unforeseen market shifts), or are they typical startup losses?
  
  
• Operational adjustments: Have you made consistent efforts to improve profitability by adjusting operations?
  
  
• Business-like management: Do you keep accurate and complete financial records as you would with any legitimate business?
  
  
• Expertise and knowledge: Do you and your advisors have the necessary expertise to run your activity successfully?
  
  

The more of these questions you answer affirmatively, the more likely the IRS will consider your project a legitimate business.

Why Does This Matter?

The classification of your activity impacts the deductions you can claim:

• Businesses: If your activity is considered a business, you can generally deduct ordinary and necessary expenses related to operating it. This could substantially reduce your taxable income.
  
  
• Hobbies: If your activity is deemed a hobby, your income is still taxable, but deductions for expenses are severely limited. You typically can’t deduct expenses in excess of your hobby income, resulting in potentially higher taxes.
  
  

The Importance of Good Recordkeeping

Regardless of whether you’re running a hobby or a business, meticulous recordkeeping throughout the year is crucial. Keeping clear, accurate records of your income and expenses will simplify your tax filing process and support your claims if the IRS ever questions your classification.

Need More Guidance?

Determining whether your activity is a hobby or a business can be nuanced. At Persitz CPA, I am here to help you make informed decisions about your taxes, maximize your deductions, and ensure compliance.

Reach out today for a personalized consultation and take the guesswork out of tax season!

For personalized assistance with your small business tax preparation, strategic bookkeeping, or comprehensive business consulting in Michigan, explore our services or contact Persitz CPA for a consultation.