Why it matters
Sometimes it's not clear if an activity that a taxpayer is engaged in that also produces income is a business or a hobby. Determining whether the activity is a business or a hobby is important however, as it affects whether or not certain deductions are allowed along with the calculations of, among other things, earned income, QBID, allowable Section 179 expense, self-employment tax, alternative minimum tax, and any credit available to taxpayers with earned income.
What is the goal of the activity?
One fundamental distinction between a business and a hobby is that the goal of a business is to make a profit, whereas a hobby is carried on for sport, recreation, or pleasure.
The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of
the last five tax years, including the current year. (Exception: at least two of the last seven years for activities that consist primarily of breeding, showing, training, or racing horses.)
However, for a variety of reasons a taxpayer's business may incur losses for several years and thus the IRS may presume it to be a hobby and disallow using its losses to offset other income. A taxpayer with a new business that is incurring and is expected to incur losses for several years after its inception may wish to file Form 5213, Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit to postpone the IRS determination regarding whether or not the taxpayer's activity is a business.
Factors to consider
IRC section 183 lists factors to consider when determining whether an activity is a business or a hobby. All these factors mitigate towards the activity being a business, bearing in mind that (a) no one factor is decisive, (b) the list of factors isn't all-inclusive, and (c) all the facts and circumstances must be taken into account:
- Is the activity carried out in a "businesslike manner", with the taxpayer maintaining complete and accurate books and records?
- Does the taxpayer and their advisors have the knowledge needed to carry out the activity as a successful business?
- Does the taxpayer demonstrate the intention to turn a profit by the time and effort they expend on the activity?
- Even and especially if the activity is incurring losses, does the taxpayer expect to make a future profit from the appreciation of the assets used in the activity?
- Has the taxpayer been successful in the past making a profit in similar activities?
- Are any losses due to circumstances beyond the taxpayer's control and/or are normal for the startup phase of their type of business?
- Has the taxpayer changed the way they operate their business in order to make it more profitable?
- Does the taxpayer depend on the income from the activity for their daily living?
- Has the activity ever turned a profit?
How to report
If it's a business...
- Sole proprietorship - Report on Schedule C.
- Farm - Report on Schedule F.
If it's a hobby, each item's sale is treated separately...
- Item sold at a loss - Personal losses cannot be deducted, therefore report on Schedule 1 (Form 1040) the income under Other Income and the cost of the item under Other Adjustments but only up to the amount of the income.
- Item sold at a gain - Report the transaction on Form 8949.
Additional Information:
IRS Tax Tip 2023-61 - Hobby or business: here’s what to know about that side hustle
IRS Form 5213 - Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit
IRS Publication 5558 - Activities not Engaged in for Profit Audit Technique Guide