Do You Have a Hobby, a For-Profit Hobby, or a Business?
- March 11, 2015 | Mark Berens
Reading. Gardening. Knitting. Popular hobbies, to be sure. However, at the point that you take steps to move your hobby from being a pleasurable pastime to being profitable, it’s time to factor in your tax responsibilities. Since the IRS does make a distinction between hobbies that generate a small profit and businesses that generate larger profits, (and, obviously, has no financial interest in your weekends spent birdwatching) it's important to identify which category you are in and what your responsibilities are, tax-wise.
How the IRS Decides
Essentially, three simple words are at the core of how the IRS determines whether you’re engaged in a hobby, a for-profit hobby, or a business: “Actions and Intentions.” Let's say you love to whittle cute little deer figurines:
- It’s definitely a hobby if you simply love the whittling, make zero money from it, and have neither plans nor intent to change that. Heaven for you is your porch, a chunk of basswood, and a sharp pocketknife.
- It’s probably a for-profit hobby if you really love to—and do—whittle the figurines and are intent on making some profit, no matter how little. When we say “no matter how little,” the IRS takes that literally. Technically, if you sold your whittled deer for even one dollar* at a flea market, the IRS requires you to report this dollar as income and pay taxes on it (conversely, if your expenses consistently exceed your profits, the IRS will likely say you’re a hobbyist regardless of what you think).
- It’s probably a business if you’re an expert deer-figurine whittler, you've made sizable profits for several years (meaning, you're financially dependent upon them), and you actively look for ways to expand your business and increase those profits.
What the IRS Expects You to Do About It
Once you've placed your activity in one of the three categories listed above, you're ready for the next step. If it turns out your business is "definitely a hobby" (option A), sit a spell and enjoy that whittling. If it turns out your "probably a business" (option C), carry on and get back to work (you are probably already doing what you need to do). If it turns out your business is a "for-profit hobby" (option B), follow these simple steps to get square with the IRS and set yourself up for maximum profitability with minimum penalties:
- Name your business (you may have to file a trade name certificate), build a website (or get setup on Etsy), and get some letterhead and business cards.
- Keep a separate bank account, books, and records: This is especially important for tax purposes. Woe to the business that discovers collected sales tax dollars were mistakenly spent. Moreover, should you be the unfortunate recipient of an audit, you'll be glad you have all your business documentation organized in a single location.
- Set up an office: Define a separate room in your home used only for your business.
- Develop a business plan: Show your projected income, expenses, and profit over a five- or ten-year period. This shows intent and can support your claims for certain tax deductions.
- Protect yourself: Consider forming an LLC or corporation to create legal separation to protect yourself and your personal assets in the event of a law suit.
- Get a Tax ID or Employer ID number: Drop in on the IRS and complete Form SS-4 (Application for Employer Identification Number).
- Address state taxes: Register for state sales, use, and other business taxes wherever you have determined you have established nexus. Our state tax guides can help you.
- File a Schedule C form: Along with your Form 1040, you'll want to file a Schedule C form (Profit or Loss From Business).
- Pay income tax: Review Form 1040 filing instructions to understand Federal, state, and local income tax filing rules.
- Pay self-employment tax: Visit the Self-Employed Individuals Tax Center to understand your responsibilities for filing self-employment tax.
- Pay sales tax: Remember, any sales tax you collect is not yours to keep. Be sure to understand where you have nexus and what due dates apply.
*Yep, you made two bucks. :)