A hobby is for pleasure. A business is for making a profit. Knowing the difference dictates whether you can deduct business expenses on your tax return — or not. Keep reading to learn about an IRS law known as the “hobby loss rule.”
In this article:
- The IRS treats hobbies and businesses differently. A business can deduct business expenses to lower tax liability, while a hobby cannot.
- There are steps you can take to ensure the IRS classifies your operation as a business in order to avoid triggering the “hobby loss rule.”
- Regardless of whether your income-producing activities are considered a hobby or business, you must report all income on your tax return.
What is the hobby loss rule?
Internal Revenue Code Section 183 — known as the “hobby loss rule” — limits deductions that can be claimed when the IRS considers an operation to be a hobby, rather than a business.
According to a 2023 Bankrate survey, nearly 40% of Americans have a “side hustle” — a stream of income separate from their primary occupation. When operated like a business, you can deduct certain business expenses to lower your tax liability.
However, the IRS is wary of taxpayers who claim deductions on what, in the agency’s view, is more of a hobby than a business. But here’s the catch: if the IRS classifies your operation as a hobby, you lose the opportunity to deduct business expenses, but you still must report income from the activity on your tax return.
How does the IRS determine the difference between a hobby or business?
The IRS offers the following questions as a guide to classifying an activity as a hobby or business:
- Is the activity conducted like a business?
- Does the taxpayer change their methods of operation to improve profitability?
- What is the taxpayer or their advisors’ expertise in the activity?
- Is the activity a main source of income for the taxpayer?
- Has the taxpayer made or does the taxypayer expect to make a profit?
- Is the activity profitable in future years?
- Do any losses from the activity fall outside the taxpayer’s control or are they normal in the startup phase of their type of business?
- Does the activity have elements of personal pleasure or recreation?
If the IRS suspects that your activity may fall under the “hobby” classification, the agency may request documentation, review your records, or inspect prior tax returns to make its determination.
How to avoid triggering the hobby loss rule
Register for an Employer Identification Number (EIN) from the IRS
Even if you operate as a sole proprietor, registering for an EIN — as opposed to using your social security number — adds business credibility and protects your personal SSN. Obtaining an EIN from the IRS is free and relatively simple. Find more information about obtaining an EIN here.
Keep separate banking accounts
Not only will this support your case as a business, but keeping your personal and business finances separate is a good practice — and will make your accountant very happy! So open a separate business banking account. And if you plan to use credit of any kind, open a credit card or line of credit intended specifically for businesses.
Practice accurate bookkeeping
Even if you never plan to grow your side business beyond just you, you still need to keep clean books. Work with a bookkeeper or use accounting software to track sales, expenses, and receipts.
Write a business plan
A written business plan is your North Star for making business decisions. It is also documentation that can prove your operation is a business, not a hobby, should the IRS ever request it. If you don’t yet have a business plan, now is the time to put one together.
What is considered taxable income?
Do you consider your operation to be a hobby, not a business? Regardless, the IRS still wants a piece of that income pie. Any income from the sale of services or goods is considered taxable income that must be reported on your tax return.
And don’t forget: if you receive more than $600 for goods or services via apps like PayPal or Venmo, you will receive Form 1099-K for the 2024 tax filing season.