Is It A Hobby or a Business?

If you have income or expenses from an activity, you must determine if the activity is a business or a hobby.

Generally, a business is an activity engaged in with continuity and regularity, and with a profit motive. A hobby is an activity that is missing either or both of those characteristics, and is more likely to involve a sporadic "When-I-Have-Time-For-It" involvement and/or an element of personal interest or enjoyment.

A business reports its income and expenses on Schedule C, and a net loss can usually be used to offset other income. Net income from a business may be subject to self-employment tax.

On the other hand, income from a hobby is declared as "miscellaneous income" on the front of Form 1040. The related expenses, but NOT in excess of the income claimed, can be declared on Schedule A as a miscellaneous itemized deduction subject to the 2% of AGI limitation. Net hobby income is not subject to self- employment tax. If expenses exceed income, there are rules for "ordering" the expenses, which determines which ones can or cannot be deducted.

There is a *presumption* under current tax laws that you have a profit motive if the activity results in a net income at least three of the past five years, including the current year. (Exception: For horse breeding or racing, the period is two years profitable out of seven.) However, the Internal Revenue Service does not automatically consider an activity meeting those tests to be a business, if there are other factors that indicate it is more likely a hobby (such as: personal interest/enjoyment, not conducting activity as a business, unrealistic expectations, not keeping proper business records, etc.) Conversely, if you "fail" the 3-of-5 test, you can still consider yourself a business if you are confident that the other factors will lead to that conclusion.

If you believe that your activity will show a profit by the third year, and you want to avoid an IRS challenge of the loss in the first two years, you can make an election by filing Form 5213, which requests that the IRS hold off on making an assessment based on disallowance of the earlier losses until the end of the fifth year, when it can be determined if you indeed met the "3-in-5" safe harbor. This election extends the statute for collection of the earlier years' taxes.

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Tax Disclaimer: To ensure compliance with IRS Rules, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (i) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer under the Internal Revenue Code, or (ii) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.