Not every revenue-generating activity is considered a business. Run your venture through this test to determine whether you have a business or hobby on your hands.
When I was in middle school, I created a website called Purely Ryan to review iPhone and iPad apps. If you had asked me then, I would’ve told you I was a business owner. I had a website, a posting schedule, and a loyal fanbase in my parents and friends. I was flying high.
Aside from a few gifted app downloads from pitying app developers, the venture earned close to $0 and set my parents back a few hundred dollars. Any income was accidental; I touted myself as a business owner, but I had no interest in turning a profit. It’s only now that I realize Purely Ryan was my hobby, not my business.
Not all money-making ventures are businesses; some are hobbies. Let’s explore how they differ and how they’re treated for tax purposes.
Hobby vs. business: How do they differ to the IRS?
In your heart, a hobby and a business might be the same thing. However, the IRS takes a more clinical approach. To the tax authority, a hobby is a person’s side project that happens to earn money. A business is an activity where the owner intends to yield a profit.
There’s a hobby or business rule of thumb called a safe harbor rule, which is delineated in Internal Revenue Code Section 183. If your activity earned a profit in three of the past five years, it may be considered a business.
Take Samantha, who’s been selling sculptures out of her at-home art studio for the past five years. Her income is below.
|Year 1||Year 2||Year 3||Year 4||Year 5|
The IRS inspector would furrow a brow looking at Samantha’s activity. If your side hustle doesn’t pass the first test, there’s a retake.
The IRS created a nine-point hobby vs. business test to determine whether your activity is a hobby or business:
- Do you treat the activity like a business by maintaining accounting records?
- Do you put in the time and effort appropriate to turn a profit?
- Do you depend on the activity’s income for your livelihood?
- Are the losses sustained in the activity beyond your control? Did the losses happen during the activity’s startup phase?
- Have you changed your operations to try to achieve or improve profitability?
- Do you or your advisors have the knowledge to run a successful business?
- Have you profited from running similar businesses in the past?
- Has the activity ever made a profit and, if so, how much?
- Can you reasonably expect the activity to earn a profit from the appreciation of assets used in the activity?
The questions root out whether you’re running the activity like a business or as a serendipitous way to earn extra income. If you’re answering “yes” to all of these questions, the activity is more than likely a business. If you’re scoring any lower, you should get in touch with a tax accountant for help.
Businesses and hobbies receive different tax treatment, so it’s important how you approach a money-earning activity.
How should you differentiate between hobby income and business income?
Serial entrepreneurs are often working on a few business ideas at any one time, and some of them might look more like hobbies at first. Keep their operations separate to nix the appearance of using your legitimate business to prop up a hobby. When you’re talking about the IRS, appearance is just as important as fact, so even if your companies are separate in your head, you need to make it clear on paper.
Instead of juggling your finances in one account, create separate bank accounts. Consider forming limited liability companies (LLCs) to insulate your personal assets from company debts for more progressed businesses.
Every business also needs updated accounting records. Some accounting software, such as Freshbooks, lets you house multiple business’s books under one login.
Can you take tax deductions for your hobby?
You can’t get tax deductions for hobbies under current IRS hobby rules. Before the Tax Cuts and Jobs Act (TCJA) of 2017, you could deduct hobby expenses as long as they didn’t exceed hobby income.
Now until 2025, you can’t deduct any hobby expenses, and, of course, you’re responsible for reporting and paying income taxes on hobby income. There’s no longer a tax incentive to pursue profit-generating hobbies.
The TCJA stripped miscellaneous itemized deductions from individual tax filings, striking hobby and unreimbursed employee expense deductions in the process. If TCJA lapses and the hobby deduction comes back in 2026, you could deduct expenses up to its revenue for the year. You still won’t be able to report a hobby loss, when deductions exceed revenue.
Business owners don’t play by hobby rules. Businesses can deduct any ordinary and necessary business expense, including rent, salaries, and the cost of goods sold. When your company operates at a loss, you can claim the net operating loss deduction, which allows you to have a negative taxable income for the year.
Common tax deductions you can take for your business
Unlike hobbyists, business owners can claim tax deductions that reduce a business’s taxable income. Lower taxable income translates to a lower tax bill. Check out this list of the most common tax deductions for small businesses.
1. Ordinary and necessary expenses
Most of a small business’s deductions come from “ordinary and necessary” business expenses. You can get a tax break for spending money on wages, rent, utilities, advertising, and other everyday expenses. Buying a Picasso as office decor might not pass muster with the IRS, however.
The IRS requires that you track business expenses that you claim as deductions. Pair all receipts with their corresponding transactions in your accounting records to ease the burden tax season brings upon business owners.
Some business expenses, such as meals and travel, aren’t fully deductible. Purchases of heavy machinery are also subject to depreciation, which spaces out deductions over several years. Peruse our self-employed tax deduction guide for details.
2. Home office deduction
Newly minted small businesses often start in a garage or spare room. When your home is your principal place of business, you can score a home office deduction. It offers a $5 deduction for every square foot of home office space up to 300 square feet. Alternatively, you can deduct your home office’s actual costs, calculated as a proportion of your total home expenses.
3. Qualified Business Income deduction
The Qualified Business Income deduction is the government’s way of saying, “Thank you for being a business owner.” For merely existing, the self-employed can get up to a 20% tax deduction on eligible income.
Turn your hobby into a business
Hobbies don’t have to stay as hobbies. Build a small business plan to turn your handmade jewelry or clothing design hobby into a tax-deductible activity.