Have you ever turned a passion into a side hustle? Maybe you sell handmade candles, bake custom cookies, restore classic cars, create content online, sell your artwork through galleries, craft fairs, or online marketplaces, or sell beauty and skincare products as an independent consultant. It's exciting when your favorite hobby starts bringing in money, but at what point does it become a business?
Believe it or not, the IRS cares. And the answer can affect what expenses you can deduct and how you report your income.
If It Makes Money, You Need to Report It
Let's clear up one common myth right away: Whether it's a hobby or a business, income is generally taxable. If you're earning money, the IRS expects you to report it.
The bigger question is whether you're operating with the intent of making a profit.
So...Is It a Business?
The IRS doesn't rely on one magic test. Instead, they look at the whole picture. Here are some of the questions they may ask:
- Are you trying to make a profit?
- Do you keep good books and records?
- Do you operate in a businesslike manner?
- Do you devote significant time and effort to the activity?
- Have you changed your methods to improve profitability?
- Do you have the knowledge or expertise to succeed or seek advice from those who do?
- Have you made a profit in some years or expect to in the future?
In other words, if you're treating your venture like a real business, that's a good sign.
The "Three Out of Five Years" Rule
You've probably heard that if you make a profit in three out of five years, you're automatically a business.
Not exactly.
The IRS generally presumes you're operating for profit if your activity shows a profit in at least three of the last five tax years (or two out of seven years for certain horse-related activities). This presumption can work in your favor, but it's not the only factor the IRS considers.
Likewise, if you don't meet that benchmark, it doesn't automatically mean your activity is just a hobby. The IRS simply takes a closer look at all the facts and circumstances.
Why Does It Matter?
The distinction can have real tax consequences.
A legitimate business may generally deduct ordinary and necessary business expenses, helping reduce taxable income.
Hobby income, however, is still taxable, but current tax law generally does not allow hobby expenses to be deducted on your federal individual income tax return.
That's a big difference.
Keep It Businesslike
If you're serious about turning your passion into a profitable venture, a few good habits can go a long way:
- Open a separate business bank account.
- Keep detailed records of income and expenses.
- Create a business plan.
- Market your products or services.
- Track your financial results.
- Look for ways to improve profitability each year.
These steps aren't just good business practices; they also help demonstrate that you're operating with a genuine profit motive.
We Can Help
Whether you're launching a new side hustle or growing an established small business, understanding the tax rules can help you avoid surprises.
If you're wondering whether your activity is considered a business or a hobby or you're ready to take your venture to the next level, our team is here to help. We'll work with you to structure your business, maximize available tax benefits, and keep you on the right side of the IRS.
After all, it's a lot more fun to focus on what you love when you're confident the tax side is under control.
This material is presented solely for information purposes and has been gathered from sources believed to be reliable, however, Landing Point cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Landing Point does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such. Nothing in this presentation is intended to serve as personalized investment, tax, or insurance advice, as such advice depends on your individual facts and circumstances. Advisory services are only offered to clients or prospective clients where Landing Point and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Landing Point unless a client service agreement is in place.