Today’s federal tax code is incredibly complex. Itemized deductions, Alternative Minimum Tax, and seemingly trivial distinctions can make navigating even the most basic individual return hazardous. Unfortunately, with the steep fines and penalties that the IRS assesses against errors and omissions, one small mistake can prove costly.
One of the most common mistakes that individual taxpayers make is in how they classify their extracurricular activities. From woodworking to photography, whether you classify your activity as a business or a hobby can have a dramatic effect on your tax liability. Thankfully, in an effort to ease some of the confusion surrounding this subject, the IRS has released a series of basic questions designed to help taxpayers correctly classify their activities. They mostly address profitability or intention to make a profit, and are as follows:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Does the taxpayer depend on income from the activity?
- If there are losses, are they due to circumstances beyond the taxpayer’s control, or did they occur in the start-up phase of the business?
- Has the taxpayer changed methods of operation to improve profitability?
- Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
- Has the taxpayer made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
While the results of this test aren’t definitive, if you answer most of these questions affirmatively you might be running a business.
More quantifiably, the IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five years, including the current year. It’s also worth pointing out that an expense must be both ordinary and necessary to be considered legitimate for either classification.
Why does it matter?
You might be asking “If the line between a hobby and self-employment is so blurry, does it even matter how I classify it?” The answer, of course, is that it does matter. A lot.
To start, hobby expenses are reported on Schedule A as itemized deductions, while expenses from self-employment are reported on Schedule C. This means that someone with few other itemizable expenses may not see any benefit from reporting hobby expenses, while the same person could save thousands from self-employment expenses. Most hobby expenses are also considered miscellaneous deductions, and are subject to the 2% Adjusted Gross Income floor.
Another significant difference is that hobby expenses may only be deducted up to the extent of hobby income, and any loss in excess cannot be used to offset other income. Self-employment losses, on the other hand, can be used to reduce total income on a 1040. This results in a lower AGI, and a lower tax liability overall.
It should also be noted that, regardless of how you classify your income, you must report it. Failure to report income, hobby or otherwise, can result in fines, interest, and even criminal penalties.
For more information on the distinction between a hobby and a business, contact a paid tax professional.