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Legitimate business or just a hobby? How the IRS tells them apart

Hobbies are an important part of our lives. They offer stress relief, the opportunity to develop new skills, the ability to escape from the rigors of our everyday lives, and are an important part of allowing us to remain vital and active into our twilight years.

In some cases, a hobby can become something more. It might be possible for a hobby to transition into a legitimate business, either full-time or as a side job.

The determination of whether your interests and pursuits are simply a fun hobby or a for-profit activity can have huge tax implications, particularly if you incur substantial expenses or are able to turn a profit. You might be able to deduct expenses for supplies, office space, equipment, and more.

Hobby versus business: IRS criteria

Before you risk trying to take deductions and credits that might subject you to IRS collection actions or auditing, understand that there are actually tax regulations and criteria governing the determination of whether an enterprise is a legitimate business or just a part-time hobby.

  • There is a presumption that an activity is a for-profit business as opposed to a hobby when it turns a profit (income exceeds deductions) for three out of five tax years

Simply failing to turn a profit doesn't necessarily disqualify an activity from being classified as a business, however. After all, many legitimate businesses can't generate income compared to expenses for several years (if at all). The IRS and the Treasury Department have created a series of factors that can be used to decide the hobby-versus-business question.

  • The manner in which the activity is carried out - Is it treated like a business? Are there organized records? Is proper bookkeeping being performed?
  • The taxpayer's expertise in the area - Buying proper supplies, fulfilling orders, following accepted practices in the industry or trade, and/or consulting with an expert in the field are all indicators of a legitimate business interest.
  • The amount of time and effort expended - Devoting a significant amount of free time - or even leaving your full-time job to follow this pursuit - indicate a desire to create a business.
  • The taxpayer's assumption that assets purchased will appreciate in value
  • Former profit gained or success in a previous related pursuit
  • The history of expenses and income - It is normal for any business' expenses to outpace income during start-up, but a history of eventually turning a profit is a good indication that the activity is actually a business as opposed to a hobby. This also applies to occasional profits.
  • Overall financial status - The taxpayer's greater economic outlook is very telling when it comes to the hobby-versus-business determination. The IRS might conclude that a taxpayer is attempting to legitimize a hobby in order to offset income from his or her full-time job, investments or other interests.
  • Personal pleasure, recreation or joy in performing the activity - Doing something for pure pleasure, stress relief or personal improvement could actually prove detrimental; unless there is indication of a for-profit motive, the IRS could conclude a pursuit is a hobby.

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