Do I run a Small Business or Is this Just a Hobby? The IRS Weighs In…

Surprisingly to most, there is no threshold of money that your side hustle has to generate before the IRS says, “Okay, you’ve now graduated from a hobby to a small business.” Rather, determining whether you have a small business is based on motives and profits.

What’s your motive here?... asks the IRS

If you have a profit-seeking motive, the IRS classifies your activity as a business. Since motives are subjective (and presumably everyone is “in it for the money” to some extent), the IRS uses the factors below, amongst others, to determine the legitimacy of your business:

• How much time and effort you are devoting to the business

• Whether you depend on income from the activity for your livelihood

• Whether you maintain complete and accurate books and records

• Whether you were successful in making a profit in similar activities in the past

Meet Kathryn

Let’s take Kathryn, for example. Kathryn has a great 9-5 job as a software engineer and lives in a nice apartment in the city. Kathryn also loves fitness and posting pictures at the gym. One day, she is approached by a friend who asks Kathryn if she can write a workout plan for her. Kathryn is passionate about helping others with their fitness goals, so she agrees. Her friend pays her for writing the workout plan and then refers Kathryn to three other people, who also start to pay Kathryn for her fitness plans.

After several months and a few more referrals, Kathryn starts to make a decent amount of profit from these fitness plans. But is she considered to have a hobby or a small business? The viewpoint of the IRS is that she is not writing workout plans with a motive for profit nor is she using it as a main source to support her lifestyle, so she actually has a hobby, not a small business.

Why does this matter, though?

It’s funny – whether you have a hobby or a business, the IRS requires you to report (and pay taxes on) all of your income for the year. The difference is what you can deduct as an expense to offset that income. Business owners often save a great deal of money by deducting their ordinary and necessary business expenses and, if possible, claiming taxable losses on their tax returns. Hobby owners, however, do not get the same luxury. Hobby owners are not allowed to deduct any hobby-related expenses or losses, leaving them high and dry to pay the full amount of tax on their hobby-related income.

Need more clarity on your situation?

To provide more of an objective stance rather than a “profit motive”, the IRS does offer that your activity is engaged in for profit if it results in a profit for three or more taxable years during a period of five consecutive taxable years, ending with the year in question.

Good ways to prove you run a business activity

In the event of an IRS audit, it would help to have the following on-hand to support your claim as a business:

· A written business plan

· Accurate records for all years in which you were engaged in the business

· Receipts for your business expenses

· Emails regarding your plans for pricing your products or services

If you need help with business planning, income and expense tracking, or determining whether your activity is a business or hobby, feel free to contact us at michael@flaxcpa.com.