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Businesses, Hobbies and Taxes

May 20, 2016  |   Tax News   |   Tags: , , , , ,  

When you engage in an activity that earns income, you need to consider if it is a business or a hobby. Depending upon whether you have a business or a hobby, your tax liability changes. A business is required to pay certain taxes, including income tax, estimated tax, employment tax, and self-employment tax. Also, if a business is operating on a loss, it can take the deduction on the return. A hobby, however, cannot use a loss from the activity to offset other income.

businesses-vs-hobbiesNew businesses often incur losses in the early stages of operation. Deducting legitimate losses can help them to survive and grow. It is primarily for this reason that many hobbyists prefer to be classified as a business.

How to Determine If Your Activity is a Business or a Hobby?

The IRS does not provide clear direction on what is considered a business. A few primary factors that are helpful to determine if your activity is a business or a hobby are shared below. You are considered to be running a business if:

  • You put time and effort into the activity to make it profitable
  • Your livelihood depends upon the earnings from the activity
  • You carry on the activity in a businesslike manner
  • You have the skill to carry on the activity as a successful business
  • The activity makes a profit in future years or you can make a profit in the future from the appreciation of the assets
  • The losses are beyond your control

If your hobby makes a profit in at least three of its last five years, then it is considered a profit-based endeavor.

What Happens If a Business is Run As a Hobby?

Running a business as a hobby is risky. If you are making a profit from the activity, you are legally required to pay taxes on the income. If the IRS discovers that the hobby is indeed a business, it may lead to an audit and penalties.

If you are running a business, you need to obtain an Employer Identification Number (EIN), pay certain taxes unique to employers, and keep accurate records to avoid being classified as a hobby.

Claiming deductions on your return for which you do not qualify can trigger an IRS examination. Knowing which deductions you can claim as a business or a hobby is essential to avoid an IRS investigation. You can refer to IRS ‘Deducting Business Expenses’ to understand legitimate deductions for businesses.