From wine making to collecting trading cards, many taxpayers have activities they are involved in. If the activity generates income, is the activity considered a business? Is the income taxable? Are expenses incurred in carrying on the activity deductible? The answer to these questions and their tax implication depends on whether the activity is considered a business or a hobby. The following information will be helpful.

What is the Difference Between a Hobby and a Business?

A hobby is an activity that is pursued for enjoyment or pleasure. The participant has no intention of earning income or making a profit.

A business is an activity entered into for the purpose of earning an income or with the good faith intention of making a profit. The IRS looks at the following factors to determine whether the activity was entered into with the intention of making a profit.

• Regularity of the activities
• Regularity of the transactions
• Production of income and
• Ongoing efforts to further the interests of the business

These factors are not exclusive and the IRS may consider others. The activity need not be carried on full time for it to qualify as a business.

How to Determine if an Activity is a Hobby or a Business

It can sometimes be difficult to determine if an activity is a hobby or a business. The IRS has a set of factors that taxpayers must consider when making a determination as to whether their activity is a hobby or a business. These factors are:

• The taxpayer carries out the activity in a businesslike manner and maintains complete and accurate books and records.
• The taxpayer puts time and effort into the activity to show he/she intends to make it profitable.
• The taxpayer depends on income from the activity for his/her livelihood.
• The taxpayer has personal motives for carrying out the activity such as general enjoyment or relaxation.
• The taxpayer has enough income from other sources to fund the activity
• Losses are due to circumstances beyond the taxpayer’s control or are normal for the startup phase of the type of business.
• There is a change to methods of operation to improve profitability.
• Taxpayer and his/her advisor have the knowledge needed to carry out the activity as a successful business.
• The taxpayer was successful in making a profit in similar activities in the past.
• Activity makes a profit in some years and how much profit it makes.
• The taxpayer can expect to make a future profit from the appreciation of the assets used in the activity.

The IRS requires all factors to be considered, along with any other facts and circumstances. No one factor is more important than another.

Is it Possible for a Hobby to Become a Business?

Sometimes a taxpayer is involved in an activity for enjoyment and discovers that he/she can actually make money from the activity. The hobby activity can be considered to be a business activity only if the taxpayer can prove a profit motive for the activity by satisfying the factors set forth above. Making money from the activity alone is not sufficient.

It should be noted that the converse is also true. An activity which started out as one with a profit motive, and therefore qualified as a business, can be reclassified as a hobby activity if the profit motive is abandoned or cannot be proven.

Tax Implications of Hobbies and Businesses

Income: The law requires that income from all sources be reported on the tax return. A taxpayer who earns income from a hobby activity must report that income on Schedule 1, line 8j of the 1040 return. A taxpayer who receives income through payment apps will receive a 1099-K reporting the income earned. A copy of this form will be provided to the IRS. For more information regarding the 1099-K see https://magdaabdogomezlaw.com/twelve-news-items-from-the-irs/

A taxpayer who earns income from a business activity must also report that income on the tax return. This income is usually reported on Schedule C of the 1040 return, unless the taxpayer has formed a separate entity such as a corporation or limited liability company. Where the income will be reported in the case of a separate entity is beyond the scope of this article.

Expenses: Expenses incurred in pursuing a hobby are only deductible if:

• The expense would be deductible without regard to whether the activity was carried on for profit or not.
• The expense is one which would be an allowed deduction if the activity were carried on for profit. The deduction, however, would be limited to the extent of the income derived from the hobby activity.

The expenses described in (1) above would be fully deductible because they are deductible under provisions of the law which have nothing to do with business deductions. The expenses described in (2) above are considered miscellaneous itemized deductions. These deductions were disallowed by the 2017 Tax Cuts and Jobs Act (TCJA) through December 31, 2025.

At this time other than paragraph (1) deductions, expenses incurred in a hobby activity do not reduce the income earned from a hobby activity. Whether the provisions of the TCJA are extended beyond December 31,2025 is not known. If the provisions are allowed to expire then, beginning on January1, 2026, expenses incurred in a hobby activity would be allowed as miscellaneous itemized deductions so long as the hobby expenses do not exceed the income from the hobby activity. Only miscellaneous itemized deductions in excess of 2% of the adjusted gross income on the return are deductible.

Ordinary and necessary expenses incurred in carrying on a business are deductible and reduce the income earned from the business. The expenses may exceed the income earned from the activity. If they do the business would generate a loss.

Losses: If the hobby activity generates a loss, the loss cannot be used to offset other income reported on the return since personal losses are not tax deductible.

If the business activity generates a loss, the loss can be used to offset other income reported on the return.

Self-employment Tax: Hobby income is subject to income tax, but it is not subject to self-employment tax (social security/medicare).

Business income reported on Schedule C is subject to income tax and self-employment tax (social security/medicare).

These are the most common tax implications for hobbies and businesses. There may be others such as contributions to retirement plans, deductions for health insurance and the alternative minimum tax. These are beyond the scope of this article.

Safe Harbor Provisions

From the above, it should be fairly clear that a business receives better tax benefits than a hobby activity. In order to claim deductions and losses, taxpayers will many times claim their hobby as a “business” on their tax return. The IRS does look at these activities very closely. By keeping accurate, detailed and contemporaneous records of the business’ activity, a taxpayer can increase the chances of having an activity classified as a business as opposed to a hobby. The taxpayer has the burden of proving that the activity is a business and not a hobby.

The law does provide safe harbor provisions for the taxpayer. If the gross income generated by the activity exceeds the expenses for 3 or more out of the 5 previous taxable years, the activity is presumed to be carried on for profit. In this situation, the burden shifts to the IRS to show that the activity is a hobby and not a business. In the case of horse breeding and racing, the period changes to 5 out of 7 taxable years.

Making a profit is not required for an activity to be considered a business, however, there must be a profit motive for the activity. An enterprise that is losing money every year will not be able to rely on the safe harbor provisions and may risk having the IRS reclassify it as a hobby activity. Keeping good records throughout the business’ existence to establish a profit motive is crucial to defeating the classification of the business as a hobby.