When it comes to starting a business out of something that was once a hobby, it can be hard at first to differentiate between making a little money from something you love to do, and having a fully fledged business. However, if you want to stay on the right side of the IRS and continue to make money, you’ll need to decide which of the two options most accurately describes what you’re doing.
What’s the difference between a business and a hobby?
Let’s look at how the IRS defines them both, since that’s what really counts:
- A business – this operates to make a profit
- A hobby – something recreational that doesn’t make a profit
However, it’s entirely possible that what you’re doing, may falls in between the two, making it hard to decipher the correct definition. If you’re not sure which definition applies to you, you can always take the IRS hobby versus business test, which is formed of nine parts.
The IRS hobby versus business test
Think carefully about your answers to the following questions to help you determine whether you’re carrying out a hobby, or making money from a business:
- Do you maintain complete and accurate books and recordsand carry out the activity in a business-like manner?
- Does the time and effortyou put into the activity show your intent to make it profitable?
- Do you depend on incomefrom the activity for your livelihood?
- Are lossesdue to circumstances beyond your control or normal for the startup phase of your type of business?
- Do you change methods of operationto improve profitability?
- Do you and your advisors have the knowledgeneeded to carry out the activity as a successful business?
- Have you had successin making a profit in similar activities in the past?
- Does your activity make a profitin some years? How much profit does it make?
- Can you expect to make a future profit from the appreciation of the assetsyou use?
There’s also a general rule of thumb from the IRS that taxpayers may find helpful:
If you have an activity that is profitable for three out of five consecutive years, then it’s considered by the IRS to be a business. Additionally, if you breed, show, train, or race horses, the activity is considered for profit if you turn a profit for two out of seven consecutive years.
Let’s look now at the taxes that may or may not be involved:
Hobby versus business tax law
When you start a business, there are some tax incentives that someone pursuing a hobby simply wouldn’t be entitled to. If you’re running a business, you can deduct qualifying ordinary and necessary expenses, and if the IRS have classed yours as a business, not a hobby, you can take a tax deduction for eligible losses.
If you want to turn your hobby into a business, here are some tips to increase your chances:
- Create a business plan
- Decide upon the structure of your business (you may find advice from an entity management firm helpful)
- Set up federal, state and local tax accounts
- Obtain the necessary business licenses and permits
- Purchase business insurance
- Select an accounting system
- Keep accurate and detailed records
If you’ve determined that yours is a business and not a hobby, you may find it cost-effective to outsource some of your requirements, especially if you’re not particularly business savvy, and can’t afford to employ anyone in-house.