You’ve done it. You’ve turned your passion into a side hustle. That little Etsy shop selling custom dog sweaters is actually making money. Your weekend woodworking projects are now adorning the homes of happy customers. You’re getting paid to do something you genuinely enjoy. It’s the dream!
But as you happily deposit those checks, a shadowy figure looms in the distance. It’s the IRS, and it’s squinting at you, wondering, “Are you having a little too much fun with this?”
Welcome to one of the grayest areas in the tax code – the distinction between a business and a hobby.
The All-Important “Profit Motive”
If you have a business, you can deduct your expenses and, if those expenses are more than your income, you can take a loss. That loss can sometimes be used to offset other income, like your W-2 wages, which is a nice perk.
If you have a hobby, you have to report every single dollar of income you make. But when it comes to deducting your expenses (the yarn for the dog sweaters, the fancy new table saw), you can deduct precisely zero. Zilch. Nada. You get the tax bill for the income with none of the benefits of the expenses.
So, what separates a bona fide business from a mere pastime in the eyes of the IRS? It all comes down to one thing: profit motive. Are you actually trying to make money, or are you just trying to fund your weekend obsession?
The IRS’s 9-Point Inspection
To decide whether you’re a serious entrepreneur or just a weekend warrior, the IRS uses a list of nine factors. They won’t look at just one; they’ll weigh them all to get the full picture. No pressure, but your financial fate hangs in the balance.
Think of this as the IRS’s checklist for separating the pros from the amateurs:
- Do you act like a business? Do you have a separate bank account, keep detailed books, have business cards, or operate like a real company?
- Is this a full-time gig? The time and effort you put into the activity should indicate you intend to make it profitable.
- Do you need this money to live? If the income is your main source of putting food on the table, it looks a lot more like a business.
- Are your losses understandable? Are they just startup pains, or are they because you spent $5,000 on a trip to Italy for “research” for your pizza-making blog?
- Do you learn from your mistakes? Have you changed your methods or business plan to try to improve profitability?
- Do you know what you’re doing? Do you or your advisors have the expertise to run a successful business in this field?
- Have you done this before? Were you successful in making a profit in similar activities in the past?
- Do you actually make a profit sometimes? A history of consistent losses is a major red flag. The IRS has a rule of thumb that if you make a profit in three out of five consecutive years, you’re presumed to be in it for profit.
- Could your assets grow in value? Even if you’re losing money now, could you expect to make a future profit when you sell assets used in the activity, like a piece of land for farming?
Why You Should Care
If you want to be treated like a business, you have to act like one. Document everything. Keep meticulous records. Have a business plan. The more you can prove to the IRS that your goal is to turn a profit, the safer you’ll be.
Because while getting paid for your passion is a wonderful thing, making sure it doesn’t turn into a tax headache is even better.
