9 Questions to Help You Determine If You Have a Hobby or a Business (and why it matters)
Maybe you’ve started a new hobby with the motivation to make a little extra money. You’ve invested time and effort into learning your hobby. You’ve learned the ropes and perfected your craft. And now your hobby has the potential to turn a profit. Or maybe your hobby has already become a reliable source of income for you. (Living the dream, am I right?)
At some point, you may feel that your hobby is becoming more like a successful side hustle—or part-time business—than something you only do to relax or exercise your creativity. It’s important to properly distinguish between a hobby and a business because the difference can significantly impact your financial future, especially when it comes to filing taxes.
Why Is the Hobby vs. Business Distinction Important?
If you think you have a business, but your business fails to meet certain requirements, the Internal Revenue Service (IRS) may classify it as a hobby. This distinction prevents you from being able to claim any activity-related losses or expenses on your tax return.
On the other hand, if you’ve classified the activity as a hobby, but in reality, you’re operating more like a business, your own personal assets may be at risk if anyone you’ve sold products to should decide to sue you. You’ll want to have structured the activity as a business to protect yourself and your personal assets.
So, if you need some help determining whether you have a hobby or a business, we’ve pinpointed how the IRS distinguishes between them. We’ve also come up with a hobby vs. business test with questions and practical tips to help you determine the next steps when reporting your income earnings on your tax return.
The Hobby vs. Business Test
Generally speaking, the IRS states that a hobby is usually done for sport or recreation, while a business operates to generate a profit. Regardless of whether you have a hobby or a business, taxpayers must report any income they’ve earned on their tax returns.
To help you determine whether you have a hobby or a business, we’ve developed nine questions for you to ask yourself. The questions have been adapted from the IRS’s hobby vs. business classifications. In the case of our quiz, we use the term activity to represent either hobby or business operations.
1. Are you carrying out your activities in a businesslike manner?
If you’ve established and maintained separate personal and business bank accounts and you’ve maintained complete and accurate books, chances are you’re acting as a business owner. If you hired employees or paid for any marketing services, you’ll also be demonstrating your profit motive.
Another sure sign for businesslike behavior is if your activities are comparable to other similar profitable businesses. For example, imagine you started making ceramic earrings to let off some steam after work. You’ve since started to sell those earrings on Etsy with great success. Now, your sales resemble the activities of other ceramic earrings companies who exist to make a profit.
2. Does the time and effort spent on the activity show you intend to make a profit?
If you’re devoting a lot of your time and effort to the day-to-day tasks required to keep things afloat, this could indicate that you have entered into (and continued) the activity to make a profit. For example, if you’re spending significant portions of your week completing administrative tasks to service customers who have purchased your products, you may have a business.
On the other hand, if you only engage in your hobby occasionally, or only sell a small portion of what you make, you may not be spending enough time and effort on the hobby for it to be classified as a true business.
3. Do you depend on the income from the activity for your livelihood?
If you have other substantial sources of income year-round, the IRS might classify the activity as a hobby. But, if you rely solely on the income from the activity, even if it’s only during part of the year, it could be considered a business. For example, a teacher who supplements her annual income with wedding photography services during the summer may be considered to have a photography business.
4. Are any losses due to circumstances beyond your control?
According to the IRS, “an activity produces a loss when related expenses exceed income.” Fluctuations in the economy may impact how much profit you can generate or invest, but incurring losses out of your control doesn’t necessarily mean your hobby is considered a business.
You’ll want to consider whether the losses are normal for the type of activity you’re engaged in, especially if you’re in the startup phase. Losses of this type can mean your activities are considered a business. An extended series of losses or sustained earnings might also indicate to the IRS that you’re engaged in a for-profit activity.
5. Did you change any methods of operation to improve profitability?
If you can prove you’ve changed your operating methods to increase your profits, this might prove you’re motivated by profit and thus operating a business. For example, if you invest in any paid software services to streamline your processes, your activity may be considered a business.
6. Do you have the knowledge needed to carry out the activity as a successful business?
The IRS expects that business owners will seek out and implement best practices to increase profits and revenue. So if you answer yes to this question, you’re demonstrating that you’ve studied accepted business methods applicable to the industry you’re in. You may have even sought advice from experts, which may also indicate you have a business rather than a hobby.
7. Were you successful in making a profit in similar activities in the past?
Even if you’re not currently turning a profit (I know, the struggle is real), the IRS may consider your activity a for-profit venture if you’ve converted other similar activities from unprofitable to profitable in the past. So if you once turned a photography hobby into a profitable business, and you’re now making money from doing wedding videography (just for fun), you may be able to consider your videography activities a business.
8. Did the activity ever make a profit, and how much profit did it make?
Even if you didn’t turn a profit this year, the IRS may still consider you profitable based on past performance. The IRS says that if an activity is profitable for three of the last five years (two of seven years in the case of breeding, training, showing, or racing of horses), the activity is presumed to be for-profit and thus a business.
9. Can you expect to make a future profit from the appreciation of the assets used in the activity?
Even if you intend to make a profit from the activity itself, the IRS also recognizes profit as it relates to the appreciation value of assets—such as land—as they’re used in the activity. These profits may also constitute your activity as a type of business.
Hobby vs. Business: What Do My Answers Mean?
If the hobby vs. business test helped you discover that you have a hobby instead of a business, you aren’t entitled to business tax breaks. Since the 2018 tax year, hobby expenses and losses can no longer be accounted for under itemized deductions due to the Tax Cuts and Jobs Act.
If you think you have a business, you’ll want to keep specific records and document your profit motive for each business-related activity. Business owners typically use Schedule C to report their profits and losses and deduct a range of business expenses.
Remember, the IRS takes all of the factors in the hobby vs. business test into consideration when you file your taxes—and each is looked at equally. If you’re still not sure whether you have a hobby or a business, Financial Fitness Coaching may be able to help you determine how to prove your activity is indeed a business.
And if you want to turn what you love (and what you’re freaking good at) into a majorly profitable, income-replacing business, we can help you discover ways to do so. Wouldn’t it feel amazing to master your cash flow and build confidence in your finances?
To see how we can help you and your business, check out our Small Business Starter Bundle Course. This value-packed, low-cost course will help you understand some basic financial foundations you need to know to help your growing business thrive financially.
Or, start with our completely free Before You Budget personal finance course to make sure your own personal finances are perfectly aligned with your most closely-held goals and values.