Have you ever noticed the category of ‘hobby income’ when preparing your taxes in the past? If not, rest assured that the IRS expects taxpayers to pay income taxes on every penny they earn, regardless of its source. If you are making money on a hobby – no matter how little – you’re expected to report that income and pay taxes on.
This may not be such a big deal unless you’re a small business owner whose operations have recently been reclassified by the IRS as a hobby. Why would that happen, and what are the tax implications? Keep reading to find out.
The Difference Between the Two
Distinguishing between a business and a hobby for tax purposes can sometimes boil down to semantics. Like so many involving the IRS, there are no black and white rules that easily distinguish between hobbies and businesses. The IRS itself says taxpayers have to consider no fewer than nine different points in trying to figure out how to classify their moneymaking activities:
- How the activity is carried out in relation to maintaining complete and accurate books and records.
- If the time and effort put into the activity indicate the intent to make a profit.
- Whether or not the individual depends on the activity’s income for his/her livelihood.
- Whether or not any losses are due to circumstances beyond the taxpayer’s control.
- Whether or not the taxpayer changes any methods of operation in an attempt to improve profitability.
- The amount of knowledge the taxpayer possesses to carry out the activity as a successful business.
- Any past history of making a profit via similar activities.
- If the activity makes a profit in some years AND how much profit it makes.
- Expectations of future profit from the appreciation of the activity’s assets.
Gurian CPA, a Dallas CPA firm offering both personal and business tax services, says that certain provisions in the tax code can lead taxpayers to classify their hobby activities as businesses so they can deduct expenses and losses at tax time. This is where a person can get into trouble if the IRS decides to reclassify their business activities as a hobby.
The Tax Implications of Hobby Activity
Up through the 2017 tax year, it was possible to deduct some expenses as a hobbyist in order to reduce tax liabilities. Deductions could never exceed income, making it impossible for hobbyists to declare a loss. As such, it was tempting to classify a hobby as a business so that tax liabilities could be reduced via losses.
We say that to say all of this: hobby expenses can no longer be deducted as a result of the 2017 tax reform bill. Any and all hobby income must be reported and included in the taxpayer’s taxable income regardless of any financial investment made in the hobby in question.
This obviously creates an incentive to report a hobby as a business. However, there is a catch: the government will only allow a business to suffer losses for so long before reclassifying the activity as a hobby. As a general rule, the IRS will consider reclassifying a business if it reports operating losses in 3 out of 5 consecutive years.
Such a consideration almost always triggers an audit that will involve IRS representatives taking a look at every aspect of the activity in question. If they do determine that the activity is really a hobby for tax purposes, that will mean the end of any and all deductions. The end result will be a higher tax bill.