Understanding the Tax Implications of Hobby Proceeds versus Business Income

During the pandemic, a record number of individuals took advantage of stay-at-home orders to either develop a new hobby or turn their existing side interest into an active business.[1] As a result, the number of new start-ups in the U.S. has reached an all-time high.[2] Unfortunately, this rapid growth has also caused confusion among many individuals as to whether and when a taxpayer’s spare time activity actually becomes a dedicated business and qualifies for more favorable tax rules. This brief reviews the factors that distinguish a “hobby” from a “business” in the eyes of the IRS as well as associated requirements, common misapplications of regulations and the factors that go into a determination between the two. Understanding the differences between hobby and business activities may help individuals maximize their deductions while avoiding penalties for mischaracterizing their income and expenses.

For Starters: Profit Intent Matters

IRS guidance indicates that one of the most important distinguishing factors between a business and a hobby is the taxpayer’s profit intent. In other words, it matters whether an individual intends to make a profit from the underlying activity or is simply engaging in the activity for personal enjoyment. This distinction is critical because while, in general, taxpayers need to report income received from any activity — whether it’s a declared business or not — there are different rules regarding how expenses are treated that depend on profit intent.

Expenses for a business that intends to make a profit are usually deductible if they are ordinary and necessary,[3] which typically means the expenses are common, helpful, appropriate and occur frequently in a taxpayer’s trade or business.[4] As long as expenses meet these requirements, deductions are generally permitted even if the business has losses. Taxpayers may not only carry over the operating losses to other years, but also use them to offset income from other sources in the tax year they are currently reporting. This type of business income is usually reported on Schedule C of Form 1040 (Profit or Loss From Business), and is subject to self-employment tax.[5]

On the other hand, there are different rules if taxpayers do not intend to profit from the underlying activities. These activities are formally known as “activities not engaged in for profit” in the tax code, though practitioners commonly refer to them as “hobby activities.” Overall, tax rules limit expense deductions associated with hobby activities and any incurred hobby losses cannot be used to offset income from other sources. The rationale behind these rules is simple: Allowing business-like deductions for casual pursuits would force taxpayers to subsidize other taxpayers who are engaging in activities for enjoyment only.

How These Rules Have Changed

One reason for the confusion over hobby versus business activities is that tax rules have recently changed. For tax years before 2018, taxpayers were allowed to deduct hobby expenses exceeding 2% of the taxpayer’s adjusted gross income (AGI) under miscellaneous itemized deduction rules.  Allowable hobby deductions were subject to two additional considerations: First, a taxpayer needed to itemize his or her deductions on Schedule A of Form 1040 to benefit from this provision. Second, the deductions were generally limited to the gross income realized from the hobby activity during the same tax year. In other words, hobby activity losses could not be used to offset income from other sources. For example, if a taxpayer’s AGI was $100,000 for the year, the threshold for determining deductible hobby expenses would have been $2,000 (2% of her $100,000 AGI). Thus, if she had incurred $2,500 expenses from photography as her hobby, she could have deducted $500 of hobby expenses (the amount over the 2% threshold), so long as she had at least $2,500 in hobby income. Unfortunately, this ability to deduct hobby losses under limited circumstances no longer applies. The Tax Cuts and Jobs Act (TCJA) of 2017 suspended all miscellaneous itemized deductions for the 2018 to 2025 tax years. As a result, individuals will not be able to offset hobby income with hobby expenses until the 2026 tax year at the earliest (assuming relevant tax rules do not change). This means that taxpayers need to report their full hobby income on Schedule 1 of Form 1040 (Additional Income and Adjustments to Income) with no corresponding deductions.[6]

Obviously, this revised tax treatment means that classifying side activities as a business, rather than a hobby, is even more desirable than in the past. However, taxpayers who misclassify their hobby activities as a business may be at a greater risk for audit by the IRS, as detailed below.

Misclassification May Increase Audit Risk   

The relatively more generous tax treatment for business activities — i.e., expense deductions, loss carryover and the ability to offset wage income — provides an incentive for taxpayers to designate their hobbies as business operations in order to benefit from more deductions and subsequent lower tax payments. However, the IRS is well aware that taxpayers have long misclassified hobby activities as business operations in order to pay less tax. For instance, the Treasury Inspector General for Tax Administration (TIGTA) found that 1.2 million taxpayers might have used hobby losses to avoid paying $2.8 billion in taxes in its 2007 report.[7] When the agency updated the study in 2016, it once again found a high rate of misreporting. [8] The TIGTA used a combination of criteria (including substantial Schedule C business losses, low gross receipts from business, and high wage income) to identify roughly 10,000 tax returns that may have misclassified hobby expenses as business deductions. [9] This group of taxpayers reported average wage income of $238,634 but an average business loss of $40,000. On their business reporting side, 35% of them had no gross receipts and 64% of them reported less than $5,000 of gross receipts. The TIGTA estimated each of these taxpayers on average avoided $8,000 of federal income taxes. After detailed reviews of a sample of these returns, the report concluded that over 75% of these taxpayers misclassified their hobby activities as businesses.

Based on this updated report, the phenomenon of taxpayers inappropriately using hobby losses to reduce taxes is still prevalent. The 2016 report also indicated that IRS audit efforts should focus on taxpayers with irregular income-expense patterns, specifically high-income taxpayers with multiple years of Schedule C losses or taxpayers with several years of large losses but little to no business income. The IRS should view these patterns as red flags indicating that taxpayers may be engaging in activities for recreational and personal pleasure instead of business purposes.

Nine Factors That Help Determine Profit Intent

Given the potential penalties for misclassifying activities, it is important to understand how the IRS determines a taxpayer's profit intent. The first thing to know is that this process can be highly subjective. There is not a hard line determining how significant a taxpayer's profit motive must be to avoid an activity being considered a “hobby” for tax purposes. Instead, the relevant regulations provide nine general factors that can be used as a reference.[10] The goal of these factors is to bring as much objectivity as possible to the process of determining whether a taxpayer is conducting an activity to make a profit or just to create losses to offset other sources of income. However, the IRS notes that no single factor is determinative and that all relevant facts and circumstances should be considered. In fact, sometimes even factors not listed in the regulations could be the deciding feature. 

In addition, the tax rules include a safe harbor specifying that if an activity reports a profit in three out of five years, the IRS will presume it a business. A similar rule states that if an activity related to breeding, training, showing or racing horses is profitable for two out of seven years, then the IRS will presume there is profit motive. However, the IRS can rebut that presumption if other facts and circumstances indicate otherwise.

The most recent guidance related to these nine factors came from an IRS audit technique guide (subsequently referred to as “the guide”), published to inform its employees about the most effective ways of conducting audits.[11] However, the guide also provides helpful information to taxpayers, advisors and other stakeholders about proper compliance procedures.  These nine factors include:

(1) The manner in which the taxpayer carries out the activity

This factor essentially requires taxpayers to conduct the activity in a businesslike manner, such as keeping books and records, adopting new methods or discarding loss-making methods to improve profitability. The guide cites four factors from the Small Business Administration that are particularly helpful when it comes to determining a taxpayer’s profit intent: idea (i.e., the business vision), business plan, business bank account and business location. [12] If these items are not present, the activity is more likely to be viewed as a hobby.

It is worth noting that although the books and records should allow taxpayers to make sound business decisions, they do not need to be complex. From a substance-over-form perspective, even “shoebox” record-keeping methods done in an unsophisticated manner may be sufficient to support a taxpayer’s claim of business activities. However, in cases where taxpayers change their operating methods, these decisions need to be made with increasing profitability in mind; simply altering a business process is not sufficient to satisfy this standard.

(2) The expertise of the taxpayer or his/her advisors

The IRS believes that if a taxpayer prepares for an activity by reading books, learning about the industry or consulting experts, he or she is more likely to have a profit motive in mind. These learning activities can take various forms and can be either formal or informal. However, the guide recommends that if a taxpayer claims they consulted professional advisors, there should be evidence that they followed those advisors’ recommendations.

(3) The time and effort expended by the taxpayer in carrying on the activity

If a taxpayer devotes a lot of his personal time and effort to carrying on an activity, or if he leaves his other job to work on the activity, it supports the claim that an activity is a business as opposed to a hobby. For instance, if a taxpayer quits his job as a salaried employee to create more paintings, there is a higher chance he will be seen as having an objective to make a profit since the activity is now his only source of income.

On the other hand, a taxpayer’s profit objective may not be seen as strong if he has substantial income from other sources and does not need the profit to sustain his livelihood. However, taxpayers do not necessarily need to spend their own personal time to satisfy these income requirements. Instead, they can hire qualified managers to carry out the income-generating activity.

(4) Expectation that assets used in the activity may appreciate in value

This factor is most relevant when land or real property is an underlying consideration. Profit can come from operating an activity or from appreciation in the value of assets (e.g., land). Even if there are losses from operations, the appreciation of land value may make up for these losses and result in an overall profit. As such, the issue of whether the land and the activity are viewed as a combined activity — or seen as two separate activities — is important.

Generally, the degree of organizational and economic interrelationship, the business purpose of each activity and the similarity of various activities are the most significant considerations when it comes to grouping multiple activities. The IRS will generally accept a taxpayer’s characterization of activities either as a single activity or as separate activities unless it cannot be supported by facts and circumstances.

Special rules apply for farming. Harvesting crops and the potential appreciation of farmland is usually considered one activity if a taxpayer’s primary intent is to use the land for farming. However, if her primary intent is to profit from land appreciation instead of growing the crops, the two endeavors would only be considered as one activity if the farming activity itself generated positive income (i.e., the income derived from farming exceeded the deductions attributable to farming).[13]

(5) The success of the taxpayer in carrying on other similar or dissimilar activities

Many people consider the past as the best predictor of the future. Likewise, the IRS believes that if taxpayers have engaged in similar activities in the past and generated profits, the current activity is probably more likely to be for profit generation. As such, the experience of a taxpayer will be taken into consideration by the IRS in determining intent.

(6) The taxpayer’s history of income or losses with respect to the activity

It is common for start-up entities to incur losses, and the typical length of time for a new business to become profitable may vary across industries. However, if losses last beyond the typical start-up phase without good reasons (such as economic recessions or natural disasters), the IRS may view this as an indication that the activity is not being engaged in for profit.

(7) The amount of any occasional profits that are earned

This factor focuses on the patterns and sizes of profits. It states that if there are small, infrequent proceeds combined with large taxpayer investments or losses, there is a higher chance the profit intent is non-existent. Conversely, the guide specifies that occasional but substantial profits — accompanied by relatively small investments or minor losses — is an indicator that an activity is for profit. Finally, the opportunity to earn a substantial ultimate profit in a highly speculative venture is typically sufficient to show an activity is for profit even though there are current losses or small profits.

(8) The financial status of the taxpayer

This factor relates primarily to how a taxpayer funds her activity. If she does not have substantial income or capital from other sources, the activity is more likely to be seen as a for-profit one because the taxpayer needs the activity to be successful to provide living expenses.

(9) Elements of personal pleasure or recreation

Whether or not a taxpayer loves their work cannot be the only consideration when determining whether an activity is a hobby or business. However, the magnitude of the enjoyment factor can help the IRS decide whether an activity is hobby or business. This does not mean that an activity has to be done exclusively for profit — or without enjoyment — absent any other factors. But the presence of excessive personal motives in conducting an activity may be seen as indicating a lack of profit intent. For instance, court cases have found inadequate profit motive when a taxpayer’s primary reason for engaging in an activity was personal or when personal motives outweighed profit motives. In certain cases, a profit motivation can be implied when an activity lacks any appeal other than profit (e.g., reading the Internal Revenue Code and preparing tax returns).

State Considerations Also Matter

An additional issue at the state level is that, regardless of whether a certain activity is a hobby or a business, taxpayers may need licenses to operate in a particular state. They may also need to collect retail sales and use taxes. For instance, South Carolina has a dedicated webpage to inform taxpayers that it has different rules for arts and crafts sellers at events and festivals versus online sales when it comes to licensing.[14] In Texas, sellers that engage in “occasional sales” are exempt from permit or sales tax requirements.[15] The occasional sales exemptions are either based on the number of items sold during a certain period (fewer than two items originally bought for personal use), or the dollar amount of sales (under $3,000).

A Final Caution About Gig Work Income

During the pandemic, many taxpayers picked up gig work such as being an Uber Eats delivery driver, a seller on Etsy or a freelancer in addition to their regular job. Because the hours for these gigs are typically short and schedules are flexible, many taxpayers incorrectly assume these gigs generate hobby income instead of business income, or mistakenly believe they only need to report income from each gig that exceeds $600.[16] Although the income may not be significant, a taxpayer’s intent for profit is clear in these cases. As such, these earnings should be reported on Schedule C as business income and associated expenses can be deducted.

A Distinction Likely to Grow in Importance

Although the advice “don't mix business with pleasure” remains valuable to many, business opportunities may very well develop when a taxpayer pursues his or her passion and turns a related activity into a source of income. The shelter-in-place periods during the recent pandemic provided numerous inspiring examples of this phenomena. However, there are differences between budding entrepreneurs and casual crafters from a tax-compliance perspective. The tax rules associated with hobby income were originally implemented roughly half a century ago to limit the deduction of farm hobby losses.[17] Over time, the courts and the IRS have applied these rules to numerous other activities that were being used to report losses to offset other sources of income — and have disallowed deductions from tax shelter activities.[18] The applications of these rules now extend far beyond farming to such industries as cattle ranching, aircraft leasing, horse breeding, gambling, acting, artwork and writing, among other fields.[19] Going forward, the list of occupations affected by IRS hobby versus business rules will likely expand as innovative technologies continue to create new industries and new recreational possibilities. This also means that potential opportunities for misclassifying hobbies as businesses will continue to exist, making it even more important for taxpayers to understand the distinctions between these two activities.

Endnotes

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[1] Dougal Shaw, “The Lockdown Side-hustles that Turned into Full Time Businesses,” BBC, August 8, 2022, https://www.bbc.com/news/business-61999826; Samantha Masunaga, “Dream of Becoming Your Own Boss? These Women Made It Happen During COVID,” Los Angeles Times, September 16, 2021, https://www.latimes.com/business/story/2021-09-16/women-entrepreneurs-covid-pandemic-first-time-business-owners.

[2] Joyce Beebe, “Five Tax Benefits for Start-ups and Entrepreneurs,” Baker Institute Issue Brief No. 05.10.22, Rice University’s Baker Institute for Public Policy, May 10, 2022, https://www.bakerinstitute.org/research/five-tax-considerations-for-start-up-companies-and-entrepreneurs.

[3] Section 162 of the Internal Revenue Code. Also, see Internal Revenue Service, “Publication 535: Business Expenses,” February 17, 2022, https://www.irs.gov/pub/irs-pdf/p535.pdf. 

[4] “Trade or business” is not a term defined in tax code or regulations. However, the U.S. Supreme Court indicates this means an activity conducted with “continuity and regularity” and with the primary purpose of earning income or making profit. See page 15, Internal Revenue Service, “Activities Not Engaged in for Profit Audit Technique Guide for Internal Revenue Code Section 183,” September 7, 2021, https://www.irs.gov/pub/irs-pdf/p5558.pdf. 

[5] Internal Revenue Service, “2021 Instructions for Schedule C,” December 21, 2021,  https://www.irs.gov/pub/irs-pdf/i1040sc.pdf. 

[6] Internal Revenue Service, “Schedule 1 of Form 1040 for Tax Year 2021,” Item 8 (i) “Activity not engaged in for profit income,” last visited October 31, 2022, https://www.irs.gov/pub/irs-pdf/f1040s1.pdf.

[7] Treasury Inspector General for Tax Administration, “Significant Challenges Exist in Determining Whether Taxpayers With Schedule C Losses Are Engaged in Tax Abuse,” Ref. No. 2007-30-173, September 7, 2007.

[8] Treasury Inspector General for Tax Administration, “Opportunities Exist to Identify and Examine Individual Taxpayers Who Deduct Potential Hobby Losses to Offset Other Income,” Ref. No. 2016-30-031, April 12, 2016, https://www.treasury.gov/tigta/auditreports/2016reports/201630031fr.pdf. 

[9] The criteria include taxpayers with Schedule C losses of at least $20,000; taxpayers who reported gross receipts of $20,000 or less, but had wage income of over $100,000; and taxpayers with positive overall income in four consecutive years.

[10] Treasury Regulation §1.183-2(b): https://www.govinfo.gov/content/pkg/CFR-2013-title26-vol3/pdf/CFR-2013-title26-vol3-sec1-183-2.pdf. 

[11] Internal Revenue Service, “Activities Not Engaged in for Profit Audit Technique Guide for Internal Revenue Code Section 183.”  

[12] According to the Small Business Administration, there are a number of fundamental steps for operating a successful or profitable business. They include idea, business plan, funding, location, legal structure, name, registration, identification numbers, licenses, permits and bank accounts. See https://www.sba.gov/business-guide/10-steps-start-your-business.

[13] Treasury Regulation §1.183-1(d)(1): https://www.gpo.gov/fdsys/pkg/CFR-2012-title26-vol3/pdf/CFR-2012-title26-vol3-sec1-183-1.pdf.

[14] South Carolina Department of Revenue, “News Release: Is Your Hobby A Business? SCDOR Offers Tips To Help You Find Out,” July 14, 2022, https://dor.sc.gov/resources-site/media-site/Pages/Is-your-hobby-a-business-SCDOR-offers-tips-to-help-you-find-out.aspx. 

[15] Texas Comptroller for Public Accounts, “Garage Sales and Occasional Sales,” last revised September 2020, https://comptroller.texas.gov/taxes/publications/94-437.php. 

[16] This is the income threshold for issuing Form 1099-NEC and Form 1099-MISC.

[17] For discussion of recent court cases, see Peter Reilly, “Hobby Loss Tax Deduction Developments in 2021,” Forbes, December 11, 2021, https://www.forbes.com/sites/peterjreilly/2021/12/11/hobby-loss-deduction-developments-in-2021/?sh=6289329c4ee3; Peter Reilly, “An Unusual Tax Court Hobby Loss Opinion,” Forbes, July 1, 2022, https://www.forbes.com/sites/peterjreilly/2022/07/01/an-unusual-tax-court-hobby-loss-opinion/?sh=7f3766452962.

[18] The United States Department of Justice, “Press Release: Federal Court Orders Tax Scheme Promoter to Disgorge $50 Million in Gains From Fraudulent Solar Energy Tax Scheme,” October 5, 2018,  https://www.justice.gov/opa/pr/federal-court-orders-tax-scheme-promoters-disgorge-50-million-gains-fraudulent-solar-energy. 

[19] For a longer list of targeted activities, see Internal Revenue Service, “Activities Not Engaged in for Profit Audit Technique Guide for Internal Revenue Code Section 183,” page 17, D (4): https://www.irs.gov/pub/irs-utl/irc183activitiesnotengagedinforprofit.pdf.

 

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