The Tax Differences between a Business and a Hobby and Why It Matters

​When you incorrectly claim your favorite hobby as a business, it's like waving a red flag that says "Audit Me!" to the IRS. However, there are tax benefits if you can correctly categorize your activity as a business.

Why does hobby versus business activity matter?

Chiefly, you're allowed to reduce your taxable income by the amount of your qualified business expenses, even if your business activity results in a loss.

On the other hand, you cannot deduct losses from hobby activities. Hobby expenses are treated as miscellaneous itemized deductions and don't reduce taxable income until they (and other miscellaneous expenses) surpass 2 percent of your adjusted gross income.

Here are some tips to determine whether you can define your activity as a business. These are common characteristics of a business:

• Profit Motive. You have a reasonable expectation of making a profit.
• Effort and Income. You invest significant personal time and effort. You depend on the resulting income.
• Reasonable Expenses. Your expenses are ordinary and necessary to run your business.
• Background. You have a track record in this industry, and/or a history of making profits.
• Customers. You have multiple customers or professional clients.
• Professionalism. You keep professional records, including a separate checkbook and balance sheet; you have business cards, stationery and a branded business website.

​The IRS will consider all these factors to make a broad determination whether you operate your activity in a business-like manner. If your business doesn't fit with the guidelines above, it might be a hobby. Each case is unique, and you should seek out professional advice on making this determination. If you need help ensuring you meet these criteria, reach out to schedule an appointment.