Today, many people have started to take advantage of their hobbies, such as the case of amateur painters who sell their works, writers who decide to publish their creations or artisans of different kinds who sell their collections through some e-commerce websites.
Regardless of the hobby being developed, it will determine the type of income statement. Thus, certain deductions of some of the expenses and fees may even be possible. Some hobbyists try to get a tax deduction for their hobby expenses by treating their hobby as a trade or a business.
By disguising hobbies as a trade or business, and if the hobby expenses exceed the hobby income, they think they can report the difference between hobby income and expenses as a deductible business loss.
Not in this case! To curtail hobbies being treated as businesses, the tax code includes rules that do not permit losses for not-for-profit activities such as hobbies. The not-for-profit rules are often referred to as the hobby loss rules.
Determining Factors – If your activity is included in hobbies, or is it a business?
Logically, it will depend on the country in which you are. In the US, for example, according to the IRS, it will depend on several different factors, none of them is determinative on its own.
The IRS adopts several criteria to determine whether a hobby is considered a business or not and if you also dedicate yourself personally to take advantage of that hobby.
Start by answering the following questions:
- Do you carry out your hobby in a professional manner?
- How much time and effort are you investing in this activity?
- Does your income depend on the benefits obtained through that activity?
- Are your losses due to something normal in that type of business? Or are they due to other circumstances that are beyond your control?
- Do you have the necessary knowledge to make your activity a successful business?
- Have you obtained any benefit from similar activities before?
- How much have you earned?
- Do you expect to continue obtaining benefits with your activity in the future?
If you answered yes to most or all of the above questions, you are in luck, because you are probably running a business. And that means it’s time to get the paperwork done and file your tax return on hobby activities.
Trade or Business Presumption
It is possible that you are finally doing what is called a hobby business. This type of business is usually carried out from home and consists of semi-recreational activities. As examples, we can include the sale of rentals, art studios that are developed from home, or an artist who uses his creativity to overhaul classic cars.
A hobby business is usually considered more like a “passionate activity” than as a real startup, but what does it appear as a micro enterprise and must be managed as such when filing taxes.
According to what most taxpayers say, hobby business income must be presented in the tax return as other income, regardless of the greater or lesser benefit obtained. Expenses related to this business are deductible as miscellaneous expenses in item A of deductions.
However, if you are running a single-owner business for profit, your income and expenses should be included in Annex C of your personal tax return. In any case, if your benefits are equal to or greater than 400 dollars, you will have to pay taxes as a freelancer.
If you really want to make a profit to your hobby and get the IRS seal of approval, these are two important tips to achieve it:
Make timely and constant records. The IRS tends to consider a business as a hobby if you can demonstrate a high level of professionalism. For example, regardless of the success, you expect for your business, it will always be best to open a separate bank account for your hobby business.
Try to keep an accurate record of expenses and income, including supporting documents such as receipts, bills and other documents.
If you have recorded everything correctly, you will have an idea of the amount of money you have earned or lost. If you have not made a profit for the last three to five years, the IRS may be reluctant to classify your activity as a business.
However, if you can prove that such losses were normal and necessary to carry out your business, you may still be able to request the business condition.
Some people are tempted to classify their hobbies as businesses so they can deduct their expenses. If your hobby is still profitable, your deductions can be justified. Otherwise, pay attention:
- The IRS defines a business activity as an activity that you perform primarily in terms of income or profit and in which you are involved in a continuous and regular manner.
- The IRS will likely consider your business as a for-profit business if it’s profitable for three out of five consecutive years. But this five-year period does not begin until the first year you show a profit, and you do not get the benefit until you have three profitable years.
- These are just guidelines, not rules, but they are tricky, and you may need the help of a tax professional to know how you could be judged in an IRS audit. Also, the IRS instructs its examiners “to be vigilant in situations where the taxpayer may have manipulated income and expenses to satisfy the determination of the rule of presumption.
- It’s not because your income comes from a hobby that you do not have to report it; you do this on line – 21 of Form 1040. And you can offset the income associated with your hobby with the expenses associated with your hobby. You cannot claim a loss for your hobby to make up for your ordinary income.
- Activities with a significant tax benefit for the taxpayer or with significant expenses and little or no revenue will be examined more closely. The IRS even lists certain activities that it considers more likely to be hobbies and not businesses: aircraft chartering, artist, auto racing, bowling, craft sales, direct selling, dog breeding, artist, agriculture, fishing, gambling, horse racing, horse breeding, motocross racing, photography, rental, stamp collection, yacht charter and writing.
There are special rules and limits for deductions you can claim for a hobby. Here are five basic tax tips you should know if you get income from your hobby:
- Business versus Hobby. There are nine factors to consider to determine if you are conducting business or participating in a hobby. For more information refer to Publication 535, Business Expenses, or visit IRS.gov and type “not-for-profit” in the search box.
- Allowable Hobby Deductions. You may be able to deduct ordinary and necessary hobby expenses. An ordinary expenses are commonly accepted for the activity, and necessary expenses are helpful or appropriate. See Publication 535 to learn more.
- Limits on Expenses. You can only deduct your hobby expenses up to the amount of your hobby income. If you are spending more money than what you are earning, you have a loss from the activity. You can’t deduct that loss from your other income.
- How to Deduct Expenses. You must itemize deductions on your tax return in order to deduct hobby expenses. Your costs may fall into specific types of expenses. Special rules apply to each type. See Publication 535 for how you should report them on Schedule A, Itemized Deductions.
- Use IRS Free File. Hobby rules can be so difficult to understand but an IRS Free File can make filing your tax return easier. IRS Free File is available for you if your earning is $62,000 or less. If you earn more, you can use Free File Fillable Forms which is an electronic version of IRS paper forms. To access Free File, visit IRS.gov.
Another concern for hobbyists who are reporting income from their hobbies, as mentioned on 1040 whether, or not that income is subject to self-employment tax. Luckily, there is an exception for sporadic or one-shot deals and hobbies, which are not subject to self-employment tax.
If you have questions related to how the not-for-profit rules may apply to your activity, please give us a call. Oasatax is a CPA firm in Fremont CA, We provide value base customize accounting and tax related services to small businesses and individuals.