Do You Have a Hobby or Business?

Do You Have a Hobby or Business?

 

by Kelley Keller | Featured Contributor

 

Did you know that the IRS views hobbies as very different things than businesses? In fact, if you make a mistake when you file your taxes or claim a loss from your “business” activity for too many years, you could get into a lot of expensive trouble.

For example, you can’t deduct expenses from your tax return or claim losses related to that activity to offset your other income if you have a hobby. That’s why it’s critical that you determine if you have a hobby or business right now.

Some of the things that flag your “business” as a hobby probably seem quite subjective. For example, the IRS will look for signs that you’re pursuing an activity as a business with a goal to make money. If your activities have significant elements of personal pleasure or recreation that consistently generate losses, then it’s unlikely that the IRS will view that activity as a business.

The IRS also uses some more objective tests to determine if you have a hobby or business: the 3-of-5 Rule and the 8 questions.

 

The 3-of-5 Rule

The 3-of-5 Rule is very simple. If you’ve haven’t earned an income from your activity in any three of the last five years, then it’s unlikely that you have a business. You probably have a hobby.

 

The 8 Questions

The 3-of-5 Rule is simple, but it’s not perfect. The IRS determines if you have a hobby or business by asking eight specific questions. Here they are so you can ask them to yourself:

 

  1. Does the time and effort put into the activity indicate you have an intention to make a profit?
  2. Do you depend on the income you make from the activity?
  3. If there are losses, are they due to circumstances beyond your control or did they occur in the startup phase of the business?
  4. Have you changed any methods of operation to improve your profitability?
  5. Do you or your advisors have the knowledge needed to carry on the activity as a successful business?
  6. Have you made a profit in similar activities in the past?
  7. Does the activity make a profit in some years?
  8. Can you expect to make a profit in the future from the appreciation of assets used in the activity?

 

If you can answer yes to these questions, then the IRS will likely determine that you have a business, not a hobby.

 

How to Show the IRS You Have a Business, Not a Hobby

If you have a business, not a hobby, then the first step to make it obvious to the IRS is to keep accurate books and completely separate your personal and business finances. Set up separate bank accounts and formally form your business as a limited liability company or a corporation. In other words, become a business.

Second, you need to develop plans and make discernible efforts to increase sales and profits. And third, consult with legal, finance, and tax experts to ensure you’re doing everything correctly.

Remember, if you’re activity doesn’t generate a profit and probably won’t generate a profit in the near future, it’s probably a hobby, not a business!

 

 

 

Share :

Twitter
Telegram
WhatsApp

One Reply to “Do You Have a Hobby or Business?”

  1. Brian Hawkins

    This is one of the most clear-cut explanations for us laymen that I’ve seen to date Kelley. Thank you for that. Maybe you can answer a question that came up in our mastermind last month? If a blogger has already determined they have a hobby, do they need to show a few hundred in AdSense revenue (not profit) as personal income? Is there an income threshold that determines how much is enough to worry about?

Join the conversation

TOP