Small Business Advice - Business or Hobby

Jean Wetzler: This is Jean Wetzler. I’m talking with Monica Baker from the Small Business/ Self-employed division about determining whether an activity is a business or a hobby. Monica, how does a taxpayer know if there hobby turned into a business? Monica Baker: Many of business start out as a hobby and then turn into a profitable activity. An activity may continue to be a hobby after it produced this taxable income. If you pursue it without expecting to make a taxable profit but if you reasonably expect to earn a profit, you have more than a hobby, you have a business. Jean Wetzler: What are the tax implications for a business versus a hobby? Monica Baker: Income from an activity is taxable, whether the activity is a hobby or a business. The good news is that you can deduct the expenses up to the amount a hobby income you earn. You can’t claim a loss from the hobby. Taxpayers who incorrectly report losses from hobby activities can be subject to additional taxes, interests and penalties in an audit. Jean Wetzler: What does the IRS consider when deciding if something is a business or a hobby? Monica Baker: The IRS presumes an activity as a business if it makes the profit during at least three of the last five tax years, including the current year. The time frame is different for breeding, showing, training or raising horses. In those instances, we consider it a hobby if it earns a profit in two of the last 7 years. If the profit requirement isn’t met, the activity may still be considered a business depending on certain factors. Here are a few questions to help you make the correct determination. Do you spend enough time and effort on the activity to make a profit? Do you depend on the income for your livelihood? Have you changed how you operate? Do you carry on the activity in a businesslike manner? Do you have the knowledge needed to carry on the activity as a successful business? Jean Wetzler: How should hobby income and deductions be claimed? Monica Baker: Income earned from a hobby should be reported as other income on form 1040. Deductions for hobby activities are claimed as itemized deductions on schedule a. Take them in this order and only to the sixth step. First, take deductions that may be both personal and business related such as home, mortgage, interest and taxes. Take those in full. Second, take deductions that don’t adjust your basis such as advertising, insurance, premiums and wages. If your gross income for the activity exceeds the deductions, you’ve token the first category, take only the excess here. These expenses are deducted as miscellaneous itemized deductions. Third, take business deductions that reduce the basis of property such us depreciation and amortization. Again, take only the amount where your gross income for the activity is more than the deductions you took in the first two categories. These are also taken as miscellaneous itemized deductions. Jean Wetzler: What deductions can I take if my hobby has turned into a business? Monica Baker: If an activity qualifies as a business, you may deduct ordinary and necessary expenses. An ordinary expense is one that is common and accepted in that trade or business. And necessary expenses, one that is appropriate for the business. Personal expenses are usually not deductible. Jean Wetzler: Where can tax payers get more information? Monica Baker: If you’re a new business owner, know your federal tax responsibilities. Visit irs.gov/smallbiz, with a z for help and information. Jean Wetzler: Thank you Monica, I’ve been talking with Monica Baker of the IRS. This is Jean Wetzler.