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Hobby or Business: The IRS Takes a Stand

 

From a tax perspective, the distinction between hobbies and businesses is important because businesses can deduct losses, but hobbies cannot. The Tax Cuts and Jobs Act kept the itemized deductions for allocable mortgage interest and property taxes. However, by eliminating virtually all miscellaneous itemized deductions for tax years 2018-2025, the 2017 TCJA made it advantageous for hobbies to be categorized as businesses. (Prior to the TCJA, hobbyists were able to deduct hobby-related expenses, subject to specific income limits, on Schedule A.)

As a general rule, the IRS views a hobby as a business if it produces positive taxable income for at least three out of the past five years. Other than that, the rules are not straightforward. If the hobbyist can't prove his or her hobby is a business, losses cannot be deducted. 
Here are four things the IRS looks at to determine whether a hobby is a business:

  1. Accurate records. 
    1. Keep extensive records and receipts for all items related to the hobby.
    2. Keep your business expenses and personal expenses separate.
    3. Set up a business checking account to prove hobby-related profits and expenses are not commingled with personal expenses. 
    4. Maintain a business website or social media presence to show you are actively selling hobby-related goods or services.
    5. Collect sales tax as appropriate under federal, state and local law.
  2. Intent. Writing a business plan that sets out goals and strategies showing a path to profitability shows intent to turn a hobby into a business. In addition, it is helpful to be able to prove:
    1. Dependence on income from the hobby for your livelihood.
    2. Amount of time and effort spent trying to make the hobby profitable.
    3. Any losses that are due to circumstances beyond your control (e.g., COVID-19).
    4. Changes in operations that were intended to increase profits (e.g., enhancing your online platform or selling goods or services on platforms like Etsy).
  3. Knowledge. Showing knowledge about business in general and the hobby in particular, such as an understanding of how the marketplace operates, helps prove intent.
  4. History. Another way to prove intent to turn the hobby into a profitable business is providing proof of a history of prior business success.

Most hobbies are intended to be recreational. They aren't usually intended to be for-profit businesses. COVID-19 may have changed that for many people, but the IRS still needs to be convinced. If you follow the aforementioned guidelines, there is a better chance the IRS will view the endeavor as a business even if it operates at a loss. 

This is just an introduction to a complex topic — there are many provisions and subtleties. Be sure to get competent advice on your hobby-turned-business.

 
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Our firm provides the information in this e-newsletter for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this e-newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.
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