Every year, millions of Americans panic over taxes and the many regulations that go with their filings. For each business filing, there are stipulations for income, deductions and expenses. But as a taxpayer, how do you know if your activities qualify as a business or merely a hobby? There are several key factors to consider, and before you file, you should become familiar with any applicable legal implications associated with either designation. It is wise to initially take the time to decipher the difference between the two, so if your situation changes, you are able to make the necessary changes with a seamless transition.

Hobbies vs. Businesses

The IRS classifies business as “any activity carried on for the production of income from selling goods or performing services.” The IRS considers a profitable activity as one that makes profit during at least three of the past five years, or one that profits in at least two of the past seven years for activities related to race-horse training. On the other hand, a hobby is described as “an activity not engaged for profit.” Businesses and hobbies have different regulations on what can and cannot be deducted from taxes as expenses. But before we take a look at these differences, use the following list of questions to help determine if your activities are classified as business or hobby.

  • Do you intend to live off of the income generated? If you will depend on this activity to make a living, it is not a hobby.
  • Do you have a business model in which you intend to make a profit? If so, you probably have a business. But if the goal of your business plan is to help others, regardless of the cost to you, you may have a hobby.
  • Do you expect to make money in the future? If you bought assets, and they grow in value, you have a business.
  • Do you have the necessary knowledge to take on this activity as a successful business? If you have an education in teaching and decide to tutor for pay, it could be considered a business.
  • Did you put in the necessary investment to turn a profit? The specific goal for your activity can be a deciding factor in its filing status.
  • Do you have prior experience with making a profit from this type of activity? If you have operated this as a profitable business in the past, chances are you will be able to do so again. In this case, you probably have what’s classified as a business.
  • Do you have losses that are startup related or due to circumstances out of your control, such as weather problems? Startup costs are related to a business, whereas elements out of your control will affect a hobby.

How to Handle Deductions

One of the biggest problems faced by taxpayers is determining what they are allowed to deduct as a business expense. Incorrect or ambitious deductions are also the major causes of an audit. Too many times, a taxpayer assumes they are able to use the umbrella of a business in order to deduct daily expenses, but if the business does not follow the above guidelines, it is a hobby, and the losses should be handled differently.

In general, individual taxpayers and businesses can deduct “ordinary and necessary” expenses for conducting business. Ordinary expenses are common and accepted in your trade or business, whereas necessary expenses are helpful and appropriate for your trade or business. However, if the IRS considers your activities as not-for-profit, you cannot deduct any losses from the activity to offset other income. This limitation on hobby losses applies to individuals, partnerships, estates, trusts and S corporations. However, some deductions can be made for hobbies; these are claimed as itemized deductions on IRS Schedule A (Form 1040). These deductions are limited to only three types:

  1. Those that may be for both personal and business activities.
  2. Those that don’t result in an adjustment to basis (the gain or loss on the sale of an asset or security).
  3. Those that reduce the basis of property.

Stay Out of Hot Water

The huge number of IRS regulations can be overwhelming for taxpayers, but by understanding the differences between hobby and business activities, filing taxes and claiming deductions can be a bit less daunting. Remember that filing inaccurate tax returns can open up a number of legal ramifications for any taxpayer. So do your homework, and if it still seems a bit confusing, consult a tax advisor. Those few hundreds or thousands you save with a false tax filing aren’t worth the time and the cash you’ll spend in order to handle an audit or, even worse, defend a tax-evasion charge.