It is important to differentiate between a hobby and a business because for some people the hobby can turn into a significant income generation method that under IRS rules may classify as a business. Furthermore, it has been observed that many people do all the necessary things for the appearance of opening a business like obtaining an EIN, LLC, trademarks, even rent a building and purposely claim a loss on their taxes.
It is great to have a hobby that can be developed into a revenue generating activity in addition to the primary source of income but at what point does the hobby become a business? The question may appear trivial but it has serious consequences upon the tax return.
John for instance works in a well paying job but he also has a passion for crafting and he uses his spare time to craft exquisite items and he then sells them on Amazon. Will the IRS consider this as a hobby or as a business? The answer depends on a number of different factors that the IRS will consider. In order to understand these factors we must first try to understand the difference between a business and a hobby.
What's the Difference
Difference between a business and a hobby, from the perspective of IRS both hobby and business are different categories of income generation sources. A business is taxed for its taxable income but a business can also claim admissible expenses against that income and it can also deduct operating losses and carry them forward and set them off against future profits.
A hobby on the other hand cannot be treated in this manner and comes with more limitations. Firstly, the expenses incurred in the pursuit of a hobby can only be adjusted against the revenue generated from that hobby. If we look back at our example then John buys materials for crafting and these materials are his expense but as long as he does not generate any revenue through his crafting, he cannot claim the expenses and when he starts to generate revenue by selling his crafts, then he can only claim the expenses equal to the revenue and not more than that.
Secondly, the loss incurred in the pursuit of a hobby cannot be set off against future profits. This is one major difference between a hobby and a business. Under the Tax Cuts and Jobs Act (TCJA) 2017, itemized deductions related to expenditure related to hobbies cannot be claimed for the tax years after 2017.
It has to be noted here that it does not matter how you decide to designate your income generation activity because the IRS has the final say in this matter. You can set up your hobby as a proper small business but if it does not meet the criteria set by IRS then the IRS will categorize your activity as a hobby.
PPP and EIDL SBA Loans
IRS uses these 9 factors to determine whether an activity can be classified as a hobby or as a business, IRS takes into account all 9 factors and the usually varies on a case by case basis. We cover these factors in depth in another post.
It is therefore very important to understand the difference between a hobby and a business and have a general idea of how the IRS is going to classify your activity. Many individuals who had their hobbies set up as small businesses found this out the hard way recently when they were declared ineligible for the SBA backed PPP and EIDL loans because these loans are for small business and not for hobbies. Whenever the IRS has to decide, they will use the above mentioned 9 points. Solopreneurs should therefore know these differences before developing their hobby because knowing the difference can help them manage their activity and plan it out in a more economical manner.