Do you enjoy hunting for treasures and listing them on eBay. How about sometimes making money from it? Or do you sell some of your crafts on Etsy to pay for your supplies? But are these activities hobbies or businesses? Understanding the difference between a hobby vs. business is crucial for tax purposes. Why? Because the Internal Revenue Service (IRS) has specific rules that differentiate the two.
In this article, we will explore the IRS rules for hobbies versus businesses, including the criteria used to make the distinction, the tax implications of each, and how to determine which category your activity falls under.
What is the Hobby-Loss Rule?
A hobby is an activity you participate in that does not aim to make a profit. If your hobby generates a loss, you cannot deduct that loss on your tax return. Furthermore, this is because the IRS does not allow you to deduct losses from activities that are not engaged in for profit.
Sole proprietorships are especially vulnerable to IRS scrutiny. This is because the losses from sole proprietorships are deductible on your tax return and can offset other income.
What are the IRS Hobby vs. Business Rules?
The IRS uses a set of criteria to determine whether an activity is a hobby or a business.
Profit motive: The primary factor the IRS considers is whether you are engaging in the activity with the intent to make a profit. If you are making a profit or have the potential to make a profit, it’s more likely that the IRS will consider your activity a business.
Time and effort: The amount of time and effort you devote to the activity is also important. Spending a significant amount of time and effort on the activity may indicate that you are operating a business rather than pursuing a hobby.
Expertise: The level of expertise or experience you have in the activity is another factor. If you have specialized knowledge or training that you use to conduct the activity, it may suggest that you are operating a business.
History of profit or loss: If you have a history of making a profit or loss from the activity, it can be a factor in determining whether you are engaged in a business or a hobby.
It’s important to note that no one factor determines whether an activity is a hobby or a business. Instead, the IRS considers all of the above factors in its determination.
Can Hobby and Business Rules Apply to Online Sellers?
Online sellers are subject to the same IRS criteria for determining whether an activity is a hobby or a business. However, there are some unique considerations for online sellers to consider when it comes to hobby vs. business income.
The IRS may consider the sales volume when determining whether an online seller is engaged in a hobby or a business. If an online seller is making a high volume of sales and generating significant revenue, it may be more likely that the IRS will consider the activity a business.
Online sellers may be subject to state and local sales tax laws. This can vary depending on the state or locality. If an online seller is operating as a business, they may be required to collect and remit sales tax to the appropriate state or local government. Complying with state and local sales tax regulations can work in your favor. This is true, especially when it comes to proving your intent to operate as a legitimate business.
Online sellers need to understand these considerations. They should also seek the advice of a tax professional if they are unsure how to classify their income correctly.
How I Protect My Online Business from Being Ruled a Hobby?
There are several steps online business owners can take to avoid being labeled a hobby by the IRS. Here are some suggestions:
Establish a separate business entity: You should form a separate legal entity such as a corporation, LLC, or partnership. This can help demonstrate to the IRS that your online business is serious and intends to make a profit. Multiple owners may also show the IRS that there is a shared interest in generating income.
Maintain accurate financial records: Keeping separate and accurate financial records for the business is crucial. This includes maintaining a separate business bank account, tracking income and expenses, and creating a detailed profit and loss statement.
Follow compliance requirements: Filing taxes and maintaining appropriate licenses are necessary. These actions can demonstrate to the IRS that the business is operating in a professional and serious manner.
Consistently generate profits: A business does not need to generate profit yearly. However, a business should show a profit in some years.
Avoid commingling personal and business assets: Keeping personal and business finances separate can help avoid confusion and prevent the IRS from questioning the legitimacy of the business.
Have a business plan: Creating a detailed business plan outlining your goals, strategies, and projected profits can also demonstrate to the IRS that the business intends to make a profit.
What Happens if My Business is Ruled a Hobby?
If your business is ruled a hobby by the IRS, it can have significant financial consequences. The IRS may disallow your business-related deductions, which can result in a higher tax bill. This can be particularly costly if you have claimed deductions in previous years that the IRS later disallows. They can apply this ruling retroactively and disqualify deductions from previous tax years.
In addition to disallowing deductions, the IRS may also impose interest and penalties on unpaid taxes. For example, if you underpay your taxes because you claim deductions for a hobby that later reclassifies you as a business, you could be liable for back taxes, interest, and penalties.
Can I Appeal an IRS Ruling if I have a Hobby Ruling?
You can appeal an IRS ruling that their business is a hobby. If the IRS determines that your business is a hobby, you have the right to appeal the decision. You do this by requesting a conference with an appeals officer within the IRS. The appeals officer will review the case and make a determination based on the evidence provided by you and the IRS.
If the appeals officer upholds the IRS’s determination that the business is a hobby, you may have further recourse by filing a petition in the United States Tax Court. You have 90 days from the date of the final IRS determination letter to file a petition with the Tax Court.
Sometimes, it may be possible to negotiate a settlement with the IRS before the case goes to court. This may involve agreeing to pay additional taxes or penalties in exchange for the IRS agreeing not to pursue further legal action.
Final Thoughts on Hobby vs. Loss
The IRS has specific rules for determining whether a business is a hobby or a legitimate business. These rules apply to both traditional and online businesses. Furthermore, failure to comply with these Hobby vs. Business rules can result in the disallowance of deductions. Other consequences include: interest, and penalties on unpaid taxes and loss of certain tax benefits.
To avoid having their business classified as a hobby, you should take steps such as forming a separate business entity, keeping organized records, maintaining a separate business bank account, and avoiding consecutive years of losses. With careful planning and compliance, businesses can avoid being classified as a hobby by the IRS. This ensures they will enjoy the tax benefits and deductions available to legitimate businesses.