The line between a hobby that sometimes makes you money, and a real business can sometimes be blurred. In the internet age, it’s easier than ever for artisans, creators, writers, and inventors to share their work and make money from their product. But at what point does the hobby, which makes you money, stop being a hobby and start being a business? This is an important distinction that needs to be made if you want to avoid the IRS knocking at your door.
So how do you tell the difference between a business and a hobby and what are the tax ramifications for both? The experts at Union Community Bank help you learn the difference between the two and instruct on how to proceed successfully.
Business or Hobby?
Why Does the Distinction Matter?
The main reason it’s so important to decide if you have a company or a hobby is the impact it has on your taxes. If you are a business, but operating as a hobby, you could be missing out on tax deductions that can help you stay afloat. On the other hand, deducting business expenses when you’re not running a real company can get you into some real trouble.
Can You Tell the Difference?
Before anything else, you need to decide for yourself if you are actually a business. The IRS has some questions that will help you determine this:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from the activity?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Has the activity made a profit in some years?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
If you are answering yes to most of these questions, your hobby has likely crossed over into business territory. At that point, it’s time to make a decision – do you want to scale back and keep it as your hobby? Or, are you ready to turn your hobby into a real business?
Are There Hobby Tax Deductions?
If you decide that a business isn’t for you, there are still tax deductions available to you. Tax payers are allowed to deduct ordinary and necessary hobby expenses. An ordinary expense is an expense that is widely recognized as being common and accepted for the activity. A necessary expense is one that is considered helpful and appropriate for the activity.
Hobby deductions are much more limited than business deductions and you can only deduct the expenses up to the amount of any income you received from that hobby.
Earn back the money you spend on your hobby. Check out a Union Cash Back Checking Account today.
You’re Running a Business, How do You Prove it?
So you’ve chosen to make your hobby a business: what’s next? It’s important to make it clear that you are a business, but this can be hard to do. Many people struggle with this because there aren’t any hard and fast rules that separate the two. According to the IRS, a business must be actively trying to make a profit. So, in order to show your intention, you just need to make a profit. Easy right? Unfortunately, it’s not that simple.
Most small businesses struggle the most during their first five years, with over half failing before the fifth year. However, to show you are a business, you’re expected to make a profit for three of those first five years, which can be hard for small businesses. The important thing to remember is that you don’t need to be making a lot in profit to meet that three-year criteria. If you can show at least a few dollars in profit, that should be enough for the IRS.
If you are unable to make a profit in your first two years of business, you should be able to declare business losses on your tax return. However, if you continue doing that, it might be a sign to the IRS that your venture is actually a hobby.
Aside from demonstrating your ability to make a profit, if you want to have a business instead of a hobby, you have to take action that proves your business is valid.
Ways you can prove that your business is legitimate:
- Keep accurate and complete accounting books
- Write an official business plan
- Comply with federal, state, and local business laws
- Have all necessary permits, insurances, and identification numbers
- Market your company through social media, business cards, newspaper ads, etc.
Business Banking Starts at Union
If you want to be a business, bank like a business. Keep your personal accounts separate from your business finances. Union Community Bank has deposit accounts specifically designed with businesses in mind. With competitive interest rates and online banking available, we have the deposit account you need as you transition from a hobby to a business.
Union Business Deposit Accounts
To learn more about your options, speak to Union Trusted Advisor today at one of our 14 local branch locations. Want business advice from people with years of experience? Check out SCORE, a nonprofit association that offers small business advice, networking, and mentorship.