Do you run an Etsy shop or sell jewellery in your spare time? Have you always dreamed of turning your hobby into a business? If so, it’s important to realize that the IRS has specific tax rules about this type of enterprise. Before you take the leap from hobby to enterprise, consider the following to help you stay compliant:
If the IRS classifies your business as a hobby, you have to prove a valid profit motive if you want to claim related deductions.
If your business claims a net loss for too many years or fails to meet other requirements, the IRS may classify it as a hobby. For tax years beginning in 2018, this will prevent you from claiming any hobby-related expenses against your hobby income.
In the eyes of the IRS, if you start a business, the intention is to profit from it. If you do not intend to profit, it’s likely that your “business” will be classified as a hobby. The IRS considers many factors to determine this, including:
– Do you put in the necessary time and effort to turn a profit?
– Have you made a profit in the past, or can you expect to make one in the future?
– Do you have the necessary knowledge to succeed in this field?
– Do you depend on income from this activity?
– Are your losses beyond your control?
Generally, if your business has not shown a profit in at least three of the prior five years, the IRS will categorize your business as a hobby. If your business includes horse training, breeding or racing, this may be extended to a profit in two of the prior seven years.
The major consequence of a hobby classification is that it doesn’t allow you to claim losses. However, if you have a hobby expense that is also a deductible personal expense, such as a home mortgage deduction, it can be deducted in full.
Keep in mind that for tax years after 2017, there are no miscellaneous itemized deductions. This means that there are no hobby expenses that can reduce your hobby income.
The IRS is always watching… so be careful about running a hobby as a business
Operating as if your hobby is a business can trigger an IRS audit. So, be sure to maintain accurate records. A written business plan detailing your intent to turn a profit and how you will handle losses will also help demonstrate that you mean business!