It can take time for entrepreneurs to realize their dreams. Often new ventures are nurtured on the side for years while their owners continue to earn steady paychecks from someone else. But at what point does your “hobby” become a business for IRS purposes?
It boils down to your intention of making a profit.
As far as the federal government is concerned, a hobby is not a profitable endeavor. If a potter spends all day crafting bowls and vases, gives most of the inventory away, and only occasionally sells a piece, then making ceramics is clearly a hobby. But if that same potter opens the studio to the public in the hopes that shoppers will pay fair market value for the handmade goods, the enterprise is a business. That’s because the artist intends to earn a profit on the sales of the bowls and vases.
It doesn’t matter whether sales are slow or even nonexistent. If the potter is charging a price that would cover the cost of materials plus the overhead of running the studio with some cash left over, then IRS sees the operation as a business.
Uncle Sam presumes that any activity that has turned a profit during three of the past five years — including the current year — is a business.
Beyond that, the agency looks into what the business owner has done to try to earn a profit. Factors include time and effort spent on the business, knowledge of the industry, and the potential to make profit in the future. If there were losses, the IRS will take into account whether that happened during the startup phase.
Why does an entrepreneur care if the startup is considered a hobby or a business?
Because if the IRS considers it a business, the owner is generally able to deduct ordinary and necessary expenses that come along with operating a business in that particular field.
Under Internal Revenue Code 183, often called the “hobby loss rule,” hobbyists may only deduct expenses up to the amount that the hobby brought in. Losses from that hobby may not be used to offset any other income.
If your side venture regularly generates income, it may be time to go through the IRS checklist to see whether it is considered a full-fledged business that qualifies for tax benefits.