How to determine: hobby vs. business

No matter if your business is something you’ve been doing for years or a hobby you just started to make extra money, the money earned from this activity must be reported on your tax returns. In this video, Nayo Carter Gray explains the differences between hobbies and businesses and how you can ensure your business isn't overpaying on taxes.

Nayo Carter-Gray
Nayo Carter-Gray

“Making Accounting a Little Less Taxing”® is Nayo Carter-Gray’s goal as owner and founder of 1st Step Accounting, a virtual accounting practice located in Baltimore, MD. Nayo is an Enrolled Agent, a Gusto Ambassador, and a QuickBooks Online Advanced Certified Pro-Advisor. She was also named one of the Top 50 Women in Accounting and Forbes Top 100 Tax Twitter accounts to follow two years in a row.

Why is this classification important for your business?

There are over 25.7 million solo businesses in the U.S., and this number is forecasted to keep growing. With that many businesses being reported there is the potential for lots of tax revenue to be generated for our economy and the potential for abuse. A 2007 TIGTA report found that in 2005 approximately 1.2 million taxpayers may have used hobby losses in order to potentially avoid paying $2.8 billion in taxes. So, as you can imagine, this is a hot topic for the IRS.

“A key factor here is to identify if your business is or isn’t a hobby to determine how much of that income is going to be taxable, and ensure you are not overpaying on taxes.”

Hobby vs. business – how to determine?

In order to determine if your business should be classified as a business, the IRS has 9 questions it likes to ask. So let’s go over them below.

1. Is the activity carried out in a BUSINESSLIKE manner, and is the taxpayer maintaining complete and accurate books and records?

With this question, they want to check if you are really treating the business as a business. Do you set up appointments to meet with clients? Do you have a website and business cards to advertise your goods and services? Do you have a business bank account or a bookkeeping system?
All of these can increase your odds of being seen as a real business.

2. Does the time and effort you put into the activity indicate you intend to make it PROFITABLE?

The profit motive should be the foundation of every business. Is the time and energy you are spending building this business going down a path to help you earn some money? Hopefully, the answer is YES.

“Profit motive should be the foundation of every business.”

3. Do you depend on income from the activity for your LIVELIHOOD?

One of the main factors is if the profit from this business is going to help you pay your bills and take care of you and your family. If you can prove that you are using the earnings to sustain or improve your lifestyle and not try to reduce any other taxable income with losses, you will be in good shape here.

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4. Are your LOSSES due to circumstances beyond your control?

Businesses don’t always start profitable and the IRS knows this. Sometimes it takes years for companies to turn a profit and it’s even harder in certain industries. You need to be able to prove that your lack of sales could be due to factors beyond your control or that you are just in the normal startup phase of building your empire.

“Businesses don’t always start profitable and the IRS knows this. Sometimes it takes years for companies to turn a profit and it’s even harder in certain industries.”

5. Do you change your methods of operation in an attempt to improve PROFITABILITY?

This is a continuation of the last question. If the business isn’t getting any sales, are you altering your methods to try and get your goods or services in the right position to be purchased? The key here is to recognize that the business is not selling enough and adjusting things to land that next big sale.

6. Do you or your advisors have the KNOWLEDGE needed to carry on the activity as a successful business?

If you recognize that your business isn’t doing as well as you think it should be, are you learning new techniques to improve profitability? Are you reaching out to operations, marketing, or financial experts to help you discover if you have issues with your positioning in the marketplace?

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7. Were you successful in making a profit in SIMILAR ACTIVITIES in the past?

If this isn’t your first foray into the business realm, can you prove that you were able to manage a successful business in the past? The IRS loves a good track record, so experience building a booming business will work in your favor.

8. Does the activity make a profit in some years and HOW MUCH PROFIT does it make?

Businesses have their ups and downs. This is where having a bookkeeping system comes into play. You may need to prove that your business was profitable in the past even if it isn’t now. Some industries and jurisdictions have a harder time consistently turning a profit, so having those good financial records will be important.

9. Can you expect to make a future profit from the APPRECIATION of the assets used in the activity?

An asset in this case could be equipment, tools, or inventory that you need to run the business. The IRS wants to check if these assets could increase your chances of earning more or higher revenues.

“Businesses can have their ups and downs. This is where having a bookkeeping system comes into play.”

Final tips

To make sure your business is operating like a business, check out the experts’ tips below:

  • Keep track of your appointments – having a record of your business activities highlights that you take running the business seriously.
  • Use separate bank accounts for personal and business transactions – the IRS does not like you commingling funds. If your business transactions are in the same account as your personal ones the IRS may try to disallow those deductions. Avoid it by simply using separate accounts.
  • Create a formal bookkeeping and accounting system – this is the foundation needed in order to help you generate reports to maintain tax compliance and grow profits.

*The purpose of this page is solely to provide information and should not be considered as financial advice.
**Melio does not provide legal, tax or accounting advice; you should consult a professional advisor before making any financial decisions.