Determining whether your side business is a hobby or a business for tax purposes can be difficult, whether you are selling handmade things online or providing freelancing services on the side. In this blog, we'll discuss the differences between hobbies and businesses, how they're taxed, and some tips to help you determine which category your side business falls in.
Hobbies and side hustles have become increasingly popular over the years, and for good reason. They offer people the opportunity to explore their passions, make some extra money, and even turn their interests into a full-time career. However, there's a big difference between having a hobby and running a business, and it's essential to understand the distinction. In this post, we'll explore the differences between hobbies and businesses and provide some tips for taxpayers to determine which category their side hustle falls under.
The Difference between Hobbies and Businesses
The main difference between hobbies and businesses is the intention to generate profit. Hobbies are activities that individuals engage in for personal enjoyment, relaxation, or fulfillment, without the primary objective of earning money. Businesses, on the other hand, are activities that are carried out with the primary goal of generating income or profit. Although a hobby may generate some income, it is usually incidental, and the activity is not pursued with the primary purpose of earning money.
Tax Implications
One of the most significant differences between hobbies and businesses is how they are treated for tax purposes. If an individual earns more than $600 in a year from their hobby, they must report that income on their tax return. However, they cannot deduct expenses related to the hobby, except to the extent that they exceed 2% of their adjusted gross income.
In contrast, businesses can deduct expenses related to the activity, such as office supplies, marketing costs, and equipment. Additionally, businesses must report their income and expenses on a Schedule C or another business tax form, and they may be subject to self-employment taxes.
Determining Whether an Activity is a Hobby or Business
Determining whether your side hustle is a hobby or business for tax purposes can be a bit tricky, but there are several key factors to consider. The IRS provides guidelines to help individuals determine whether their activity is a hobby or business. These guidelines include factors such as the time and effort expended, the expectation of making a profit, and the taxpayer's expertise in the activity.
Here are some questions taxpayers can ask themselves to help determine whether their activity is a hobby or business:
Are you carrying out the activity in a businesslike manner and keeping complete and accurate books and records?
Do you intend to make a profit from the time and effort you put into the activity?
Does your side hustle make a profit in some years, and if so, how much profit does it make?
Can you expect to make a future profit from the appreciation of the assets used in the activity?
Do you depend on the income from your side hustle for your livelihood?
Are any losses due to circumstances beyond your control, or are the losses normal for the startup phase of your type of business?
Do you change your methods of operation to improve profitability?
Do you and your advisors have the knowledge needed to carry out the activity as a successful business?
By answering these questions, you can get a better understanding of whether your side hustle is a hobby or a business. Keep in mind that there is no single factor that determines whether an activity is a hobby or a business. Rather, it's the combination of all the factors that the IRS considers when making a determination.
Therefore, having a hobby or side hustle can be a great way to explore your passions, make some extra money, and even turn your interests into a full-time business. However, it's essential to understand the difference between a hobby and a business and how they are treated for tax purposes. By asking the right questions and keeping good records, taxpayers can determine whether their activity is a hobby or a business and avoid any surprises when tax time comes around. Remember, whether it's a hobby or a business, good record-keeping is key.
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