With tax time right around the corner, it is important that you ask yourself the following very important question: do you just have a hobby business or have you turned it into a real business?
For many people, developing multiple income streams and side incomes starts as a hobby business. For a few, these hobby businesses turn into real businesses. Why does this matter?
Well, it matters because the IRS taxes business income and hobby income slightly differently, and it is important that you know the differences so you don’t get audited, owe penalties, and more.
Do I Have a Hobby Business or Real Business?
Generally, an activity qualifies as a business if there is a reasonable expectation of earning a profit. In order to make the determination if a business is a real business, the IRS puts forward the following questions you should ask yourself:
- Does the time and effort put in indicate an intention to make a profit?
- Does the owner have the knowledge necessary to make the business a successful business?
- Has the owner made a profit from similar activities in the past?
- If there are losses, are they due to start-up costs or unforeseen expenses?
The IRS presumes that an activity is for profit if it makes a profit in at least three of the last five years, including the current year.
This definition can still be tough for a blogger – especially a personal blogger who had no real intent to make a profit, but has found advertising income a lucrative way to monetize their hobby. However, you could still call a blog a hobby business, if you never had the intent to make a profit, there are just some tax implications that you need to consider.
The Tax Implications
The biggest tax implication of whether you have a hobby business or real business is how much of your expenses you can deduct.
If you are operating a regular business, all necessary and ordinary expenses may be deducted. The IRS considers a necessary expense one that is appropriate for the business. For example, a necessary expense for a blog would be hosting, since you can’t blog without a web host. Now, for a regular business, if you have a loss overall, this loss would offset other income on your tax return.
The big difference comes into play with hobby businesses, where losses don’t offset other income. The reason is that expenses for hobby businesses are actually taken as itemized deductions on a Schedule A. And with that being said, the deductions for expenses related to the hobby (say advertising), may only be deducted to the extent that gross income from the hobby is more than the deductions. That is how hobby accounting differs from business accounting.
Should You Make Your Hobby a Real Business?
In my case, I turned my hobby into a real business so that I could take full advantage of all the deductions. If you are turning a profit, it doesn’t really matter too much, except for the fact that I have to pay for self-employment tax, where as a hobby you wouldn’t have to. But as your income increases, it may be harder to justify a hobby business is NOT a regular business. Especially if you’re utilizing online accounting programs to keep track, and are operating everything more like a business.
Remember, I’m not a tax expert, but just talking from my experience. If you want to learn more, check out the IRS Website about Hobby Business Deductions.
Are you planning on taking your hobby to the business level this year?