Classifying Hobby and Business Income

February 3, 2023

Whether you’re an entrepreneur looking to turn your passion into profit, or a hobbyist seeking to maximize your enjoyment while minimizing your tax burden, this blog has something for you.

We’ll delve into the often-blurred line between hobby vs. business income, exploring the unique tax implications of each and offering practical tips for maximizing your success.

So, grab a cup of coffee, sit back, and get ready to learn all about the exciting world of hobbies and businesses!

What is Hobby Income?

Hobby income is money earned from a recreational activity pursued with no intention of making a profit.

Hobby income refers to the money you earn from an activity primarily for leisure or personal enjoyment, not profit.

For example, if you enjoy painting as a hobby and sell some of your paintings. In that case, the income you earn from selling your paintings is considered hobby income.

Report your hobby income on your tax return as miscellaneous income on Form 1040. You may deduct related expenses only up to the hobby income you earned. Expenses exceeding your hobby income cannot be claimed as a deduction.

What is Business Income?

Business income is money earned from a commercial activity pursued to make a profit.

This includes businesses such as:

  • Retail stores
  • Restaurants
  • E-Commerce stores
  • Affiliate marketers

Business income is reported on your tax return on Schedule C if you’re a sole proprietor or on Form 1120 if you’re a corporation. 

Business expenses are deductible and can be used to offset your business income, reducing your tax liability.

How is hobby income taxed?

The IRS taxes hobby income as ordinary income at the individual tax rate, which you report on your tax return, typically on Schedule 1 (Form 1040) under “Other Income.”

Unfortunately, hobby expenses aren’t deductible and can not be used to reduce your tax liability.

Keeping accurate records of all hobby income and expenses is crucial. The IRS may require documentation to support any deductions claimed.

Suppose you have a hobby that is not just a hobby but is instead a business or for-profit activity. In that case, you may be subject to self-employment taxes and additional tax obligations.

How is business income taxed?

Business income is taxed as self-employment or income earned from a pass-through entity.

The IRS considers self-employment income taxable at the self-employment tax rate, which covers the employee and employer portion of Social Security and Medicare taxes. 

You must report self-employment income on Schedule C (Form 1040) and pay federal income tax.

For income from a pass-through entity, such as a sole proprietorship, partnership, limited liability company (LLC), or S corporation, the individual tax rate of the owner(s) applies. You, as the owner, must report the income on your tax return.

For instance, a single-member LLC reports its income on Schedule C (Form 1040) as a sole proprietorship. 

A partnership or multi-member LLC reports its income on Schedule K-1 (Form 1065) and then on the individual tax return of each partner.

In addition to federal income tax, you must also pay state and local taxes for your business, such as sales tax, property tax, and business license fees.

IRS Safe Harbor Rule

The IRS safe harbor rule is a term that describes a set of rules that help determine whether an activity is a hobby or a business. This is important because it affects how much money you can spend and write off on your taxes.

To be considered a business under the safe harbor rule, you must show that you made a profit in at least 3 out of 5 years

The IRS will likely consider your activity a hobby if you don’t meet this requirement.

How to Determine If Your Activity is a Hobby or a Business

Determining whether your sales are a hobby or a business can be necessary for tax purposes, as the IRS treats hobby and business income differently.

Here are a few factors that can help you determine whether your sales are a hobby or a business:

  1. Profit motive: If your main goal is profit, your sales will likely be considered a business. If you engage in sales activities as a hobby or to supplement your income, they are more likely to be considered a hobby.
  2. Business-like activity: If you engage in sales activities professionally, such as keeping accurate records, advertising, and investing in equipment or inventory, your sales are more likely to be considered a business. If your sales activities are casual or sporadic, they are more likely to be considered a hobby.
  3. Frequency of activity: If you engage in sales regularly and continuously, your sales are more likely to be considered a business. If you only sell occasionally or seasonally, they are more likely to be considered a hobby.
  4. Dependence on income: If your sales income is your primary source of support, your sales are more likely to be considered a business. If you rely on another source of income as your primary source of support, your sales are more likely to be considered a hobby.

Understanding whether your income is from a hobby or a business can significantly impact your taxes at the end of the year.

Tax Implications of Hobby vs. Business Income

The distinction between hobby and business income has significant tax implications. 

Hobby income is taxable, but you cannot deduct any expenses related to the hobby.

On the other hand, business income is taxable, and you can deduct business expenses related to the business activity, such as supplies, equipment, and advertising.

Additionally, you may be required to pay self-employment taxes, including Social Security and Medicare, on your business income if you have a business.

If your activity is considered a hobby, you are not required to pay these taxes.

Misclassifying hobby income as business income can result in tax penalties because the IRS treats these two types of income differently.

If the IRS determines that a taxpayer has misclassified hobby income as business income. The taxpayer may be subject to tax penalties and interest on underpaying taxes.

We Take The Stress Out of Filing Your Taxes

Understanding the critical differences between hobby and business income can ensure you comply with tax laws and minimize tax liability.

If you’re unsure whether your activity is a hobby or a business. In that case, it’s a good idea to consult an experienced tax attorney to help you accurately report your income and pay the correct taxes.

Speak with an Attorney

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