How the IRS Determines if my Hobby Is a Real Business or Not

Posted on December 17, 2021December 18, 2021 by Mark Harrell

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INTRODUCTION

How can I know whether I Have a Business or a Hobby? (How The IRS determines if my Hobby Is a Real Business)

IRS Determines if a Hobby Is a Real Business

If you fall under the category of people who have started a business but are not making a profit and you must have heard that the IRS will not accept business deductions if it sees your business as a hobby.

It is very expedient that we understand It's the difference between a business and a hobby, this is because an honest business can remove its expenses and possibly take a loss if it is not beneficial. But in a situation whereby the IRS sees your activity as a hobby, you won’t get a loss to offset other income after you have subtracted expenses.

In this article, we will be discussing the criteria employed by the IRS to decide if an activity is classified as a business or a hobby.

How can I know whether I Have a Business or a Hobby? (How The IRS determines if my Hobby Is a Real Business)

The essence of differentiating between legitimate businesses and hobby activities by the IRCC is for the purpose of taxes. In addition to this, a business is considered a for-profit entity while a hobby activity is a not-for-profit activity. Aside from what the IRS states, we all know that a legitimate business has a major purpose of “income or profit” and continuously participates in a profit- or income-seeking activity.

A summary of the IRS nine factors test

Below is the list of 9 factors used by the IRS to decide if an activity is a legitimate business or a hobby, considering each case based on its benefits:

They check how you run your day-to-day business to know if you run it like a proper business by having business records, business checking account, and so on.
They check whether you strive to bring in customers by putting your time and effort into marketing and other activities
They also find out if you depend on the income from this activity for your daily survival.
They want to know whether your business losses are beyond your control or typical startup losses
They check if you incorporate changes into your business in a bid to increase your profits
They check if you are an expert in your area of business and the kind of business advisors you hire.
They want to know if you have previously been successful in similar businesses
Are there years you make a profit, if yes, how much?
Are there possibilities that you will make a profit in the nearest future?

There is certain income that is considered to be hobbies and they are the ones that the IRS pays close attention to, they include activities such as craft sales, dog breeding, fishing, horse racing, photography, and writing. This is as a result of the fact that there is no room on your tax return where you assign basically for the deductions from your activity as a business or hobby.

A summary of Business vs. Hobby rules for business types

Small businesses subjected to these business-vs-hobby rules are the ones established as partnerships, sole proprietorships, or limited liability companies (LLCs).

A detailed explanation of how to subtract expenses as a business or hobby

As a business owner of a for-profit business, you can fully subtract ordinary and necessary business expenses. Any loss the business has can be used to take care of other income on the owner's tax return.

Previously, hobbyists could subtract expenses that are up to the amount of their hobby income, but this is no longer applicable. The Tax Cuts and Jobs Act as at the beginning of the 2018 tax year, canceled the ability of hobbyists to subtract non-business expenses as miscellaneous expenses and the business owner still has to report the hobby income on their tax return.

A summary of how you can postpone IRS Determination on your business case

You can make an election for the IRS to give you some time so you can make a profit if you want them to postpone deciding whether your activity is for-profit or not-for-profit. You should make Use of Form 5213 for this purpose. This election should be made in the space of three years after the date of your return for the first tax year you participated in this activity is due, for example, if you started your business in January 2021, ensure that you make this election before the end of the year 2023.

This election gives you an additional 2 years to show a profit, this is the major advantage of the election. In a case whereby you do not have the needed years of profit, the limit can be applied to the succeeding year but with a loss in the period of five-year.

How can I enhance my position as a For-Profit Business?

For the IRS to consider your business as a legitimate one, following and showing the business practices listed below will help you achieve your aim, they are:

-You have to set up a separate business checking account
-You have to separate business from your personal expenses
-You have to maintain a good record-keeping system in business
-You have to register your business as an LLC with a state
-You have to obey other state and federal tax laws which includes collecting sales tax and paying yearly state business renewal fees
-You must have regular business hours or maintain a business website

Before the IRS declares my business a hobby, how many years of losses can I have?

Before the IRS can consider an activity to be a business, you must have made a profit from it for a minimum of three of the past five years. However, what will be your fate if it doesn't? Your business will be evaluated by the IRS and determine if it's for-profit or not-for-profit.

There are yet certain factors that can be considered such as if you function in a manner that shows it’s a business if you engage in marketing and promotion to improve and draw in customers, and whether you depend on the profits for survival.

For a hobby loss, how do I calculate AGI?

The best way to describe an Adjusted gross income (AGI) is that it is an adjustment subtracted from a gross income on a tax return. This includes business income, wages, capital gains, and dividends. The IRS can audit your business tax return for the year after you have filed it if they have a question about its purpose (legitimate business or hobby). Unfortunately, if your activity was considered a not-for-profit (hobby) activity, you are not permitted to take deductions from that income to take care of other income to calculate your Adjusted Gross Income and you still have to report the income you got from this activity.

How often does the IRS audit to determine if an entity is a business or a hobby?

Well, we cannot say that there is a particular timetable for this type of tax audit, besides, they only carry out this audit if it is concerned with the activity (legitimate business vs. hobby). Certain things can trigger an audit such as:

When they find out that the activity has large expenses with very little or no income
When the losses are utilized to offset other income on the tax return
When the activity leads to a large benefit to the taxpayer
If there is no benefit to show for the past years

Furthermore, the nine factors that distinguish a business and hobby activity will be considered by the auditor.

ARTICLE SOURCE [bg_collapse view=”button-orange” color=”#0d0b0b” icon=”arrow” expand_text=”Show More” collapse_text=”Show Less” ]

IRS. “Instructions for Schedule C Profit or Loss from Business.” Page 1. Accessed Nov. 16, 2021.
IRS. “How do you distinguish between a business and a hobby?” Accessed Nov. 16, 2021.
IRS. “IRC Section 183 Activities Not Engaged In For Profit.” Page 11. Accessed Nov. 16, 2021.
IRS. “Publication 535 Business Expenses.” Page 7. Accessed Nov. 16, 2021
IRS. “Publication 529 Miscellaneous Deductions.” Page 4. Accessed Nov. 16, 2021.
IRS. “Earning Side Income: Is It a Hobby or a Business?” Accessed Nov. 16, 2021.
IRS. “Be Tax Ready – Understanding Tax Reform Changes Affecting Individuals and Families.” Accessed Nov. 16, 2021.

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