Do you collect stamps? Write stories? Craft macramé holders for hanging plants? Are these hobbies or actual businesses? The IRS has weighed in on this: “A hobby is any activity that a person pursues because they enjoy it and with no intention of making a profit. People operate a business with the intention of making a profit.” According to the agency, you may engage in hobbies or activities that could turn into a source of income.
However, determining whether that hobby has grown into a business can be confusing. To help simplify things, the IRS has established factors taxpayers must consider when determining whether their activity is a business or a hobby.
These factors are whether:
- The taxpayer carries out activity in a businesslike manner and maintains complete and accurate books and records.
- The taxpayer puts time and effort into the activity to show they intend to make it profitable.
- The taxpayer depends on income from the activity for their livelihood.
The taxpayer has personal motives for carrying out the activity such as general enjoyment or relaxation.
- The taxpayer has enough income from other sources to fund the activity.
- Losses are due to circumstances beyond the taxpayer’s control or are normal for the startup phase of their type of business.
- There is a change to methods of operation to improve profitability.
- The taxpayer and his or her adviser have the knowledge needed to carry out the activity as a successful business.
- The taxpayer was successful in making a profit in similar activities in the past.
- The activity makes a profit in some years, and how much profit it makes.
- The taxpayer can expect to make a future profit from the appreciation of the assets used in the activity.
- All factors, facts and circumstances with respect to the activity must be considered. No one factor is more important than another.
In most situations, the IRS will grant a “safe harbor” and approve an activity as a business if it has turned a profit in at least three of five consecutive years.
What if a taxpayer gets lucky and starts making a profit from an activity that was never intended to do so? The IRS has that covered too: If a taxpayer receives income from an activity that is carried on with no intention of making a profit, the taxpayer must report the income he or she receives.
If you’re not sure about your situation, consult with your qualified BiggsKofford tax professional.