Hobby or Business?

KnittingYou may think you have a crafts business … but the Internal Revenue Service won’t just take your word for it. In the unlikely event that you’re audited, you’ll have to prove you’re serious about making a profit. If you can’t, the IRS will label your effort as a “hobby” and you may have to pay back taxes and penalties.

What’s the difference? If you have a business, you can deduct your losses from other income such as salary, your spouse’s income, or interest and investment income—a benefit for the one-quarter of individually owned businesses reporting a deductible loss each year. You can do this even though you don’t expect to earn any money from your business for many years.

If the IRS thinks you have a hobby rather than a business, you can only deduct your expenses from your hobby income. So if you lose $5,000 on your crafts, you can’t deduct it from other income. This is the “hobby loss rule.” And a hobbyist can’t carry over deductions to use them in future years when income starts rolling in; they’re lost forever.

How does the IRS judge your business?

To qualify as a business under the IRS rules, you must demonstrate that your primary motive is to earn a profit with your crafts business and that you continuously and regularly engage in it over a substantial period. The IRS makes its determination in two ways:

  • If you earn a profit in any three of the last five years, the IRS presumes you’re in business and is unlikely to question you about it.
  • If you don’t earn a profit in three of the last five years, you will have to show that you behave as if you want to earn a profit. This is usually demonstrated by keeping good books and other records, possessing adequate expertise in the crafts business  and  proof that you work regularly and continuously on your business, not sporadically. What’s “regularly and continuously?” One court accepted 20 to 30 hours per week (Maximoff v. Comm’r.,T.C. Memo 1987-155); another accepted 25 hours per week for three years, then 5-10 hours per week for 2 years (Luow v. Comm’r., T.C. Memo 1971-326.) When a tax payer couldn’t establish the time spent, a court called it a hobby. (Everson v. Comm’r, 2001 TNT 115-8.)

In general, the IRS is skeptical of taxpayers who claim large business losses but who have substantial income from other sources. Unfairly or not, if you earn a modest income, you’ll fly lower on the IRS radar screen. The IRS also may be doubtful of your motives if you’re doing something that others perceive as fun.