With the rise of the gig economy, many have explored turning their hobbies into profitable ventures. As a result, the lines are blurring between hobbies and small businesses, provoking many people to wonder what impact their decisions may have on their personal income taxes. So, what is the difference between a hobby and a business?
The difference between hobbies and businesses
When thinking about the answer to that question, ask yourself whether the activity in mind is carried out for personal gratification or to generate profit. The greatest differentiating factor between hobbies and businesses is that a business operates with the intention of making a profit, whereas a hobby is pursued for recreational purposes.
If you profit from your venture, the money you make is considered taxable income, which must always be reported on your personal income tax returns. Even if the money doesn’t stem from full-time work, it still is considered a source of income.
For hobbies, you cannot deduct any expenses to offset your income under current tax law. In 2026, you may be able to deduct certain expenses from your hobby up to the amount of hobby income. However, these expenses would be included as an itemized deduction which may not be beneficial to all taxpayers. For businesses, you are able to deduct most expenses for income tax purposes.
Questions to ask when determining whether your project is a hobby or a business
- Do you perform the activity in a businesslike manner?
- Is it protocol to keep a complete and accurate recording of your books?
- Does the time and effort you put toward your activity indicate that profits are the end goal?
- Have you made a profit from the activity, and if so, how much has been generated?
- Do you anticipate making a profit from the appreciation of the assets related to the activity in the future?
- Does your livelihood depend on any income that you generate from the activity?
- Are any losses that you experience due to the activity caused by circumstances beyond your control, or are the losses typical regarding the startup phase of a business?
- Do you adjust your methods of operation with the intention of improving profitability?
The importance of good recordkeeping
When operating a business, proper recordkeeping will help simplify your income tax filing process. In addition, it will help you identify whether your business is generating a profit or a loss. Why is this important? One question to consider is whether your business claimed a net loss for many years in a row? If so, the IRS may classify your endeavors as a hobby rather than a business, which will ultimately prevent you from claiming those losses in your favor. The onus is on the taxpayer to prove you had a valid profit motive to claim deductions.
The IRS safe harbor rule
If you have generated a profit with your activity in at least three out of five consecutive years, then the IRS will view you as being engaged in the activity for the sake of making a profit.
Keeping accurate and extensive records of any profits you generated can help you prevent your business from being classified as a hobby and subsequently losing your ability to benefit from deductions. By keeping records and maintaining receipts, you can document your motive behind any profits, which may demonstrate a more professional approach to your business.
A written business plan is often a prerequisite when you want to indicate your intent for profit. It can also portray the ways that you actively modify your business to cope with any losses you face.
Determining whether your activities are primarily carried out for enjoyment purposes or with the goal of making a profit will affect your ability to benefit from tax deductions. Think about what makes the most sense for your situation and proceed from there. Consider consulting with your tax advisor if you have questions on your hobby or business.
HAVE QUESTIONS?
If you need assistance or have any questions on the information in this article, please call your CironeFriedberg professional. You can reach us by phone at (203) 798-2721 (Bethel), (203) 366-5876 (Shelton), or (203) 359-1100 (Darien) or email us at info@cironefriedberg.com.
