If your hobby earns you income, the IRS wants to know about it. But how do you report hobby income and how does it differ from small business income? Is one better than the other when it comes to filing taxes?
Why is it important to know the difference?
Knowing the differences between hobby income and business income is essential because it determines what kind of taxes you must pay and what deductions you can take.
What is the tax difference between hobby and business?
For tax purposes, the main difference between hobby income and business income is what deductions you can take.
Let’s look at the tax implications for both sources of income.
What are the tax implications for a business?
Your business income is subject to income tax, as well as a 15.3 percent self-employment tax (to cover Medicare and Social Security) if you’re self-employed.
To help offset your taxable income, you can take business tax deductions for qualified business expenses — like startup costs, internet and phone service, travel expenses, etc.— and possibly take a loss if your business isn’t profitable. You can report your business income and losses using Schedule C.
How is hobby income taxed?
You must also report any hobby income you receive on your federal income tax return. Hobby revenue is subject to income tax, but you won’t have to pay any self-employment tax as a hobbyist. You can report hobby income on Form 1040 (Schedule 1, line 8) under a section called “Other Income.”
If you earn hobby income from a side hustle, the IRS no longer allows you to deduct hobby-related expenses to offset your other income. This is a fairly recent change — prior to the 2018 Tax Cuts and Jobs Act, hobbyists were allowed to deduct miscellaneous expenses up to the amount of hobby income they earned. As of tax year 2022, you cannot deduct hobby expenses.
Hobby loss rules apply to small businesses classified as sole proprietorships, partnerships, and S corps. These rules do not apply to corporations, which are their own business entity.
When you use our tax prep software, TaxAct® will help you appropriately report hobby income by asking simple interview questions and matching your income to the proper tax forms.
At what point is my hobby considered a business?
Now that you know the difference, how do you know if your hobby activity is really a business or vice versa? The IRS looks at several criteria when determining whether to classify your income as a hobby or a business.
For your business to meet IRS guidelines, you should have made a profit in at least three of the last five consecutive years (there is a special exception to this rule if you breed, train, show, or race horses).
But if you’re still scratching your head trying to figure out how to report your income, consider the following questions:
- Do you run your activity in a businesslike manner while keeping complete and accurate business records?
- Do you put time and effort into making your activity profitable?
- Do you depend upon the income for your livelihood?
- Do you have personal motives (enjoyment, relaxation, etc.) for doing this activity?
- Do you have enough income from other sources to fund this activity?
- Are losses from this activity beyond your control or normal during the startup phase?
- Have you changed your methods of operation to try to improve your profits?
- Do you (or an advisor) have the knowledge and expertise necessary to make this activity a successful business?
- Have you successfully made a profit from similar activities before?
- Is your activity profitable during some years, and if so, how much?
- Do you expect to make a profit in the future?
The IRS considers these factors on a case-by-case basis when auditing taxpayers. Typically, it all boils down to whether you intend to make a profit or whether you are doing something just for fun with no real intent to make a profit.
The IRS has classified my business as a hobby. What should I do?
When you are used to claiming business deductions on your tax return, it can be confusing and frustrating if the IRS suddenly says your business looks more like a hobby. This could happen if your business claims a net loss for too many years in a row or fails to meet other business criteria in the eyes of the IRS.
If you have a legitimate business, it’s important to keep thorough and accurate business records and save your receipts. Detailed bookkeeping of your business transactions and a written business plan can help you demonstrate a valid profit motive to the IRS if they decide to challenge your business classification.