What is the difference between a hobby and a business from a tax perspective? When does a hobby become a business in the eyes of the IRS? If the IRS disputes your “business deductions” as a hobby it could trigger an IRS audit and result in a substantial payment to the IRS. Generally speaking, the IRS considers your activities a “business” if they are “carried on with the reasonable expectation of earning a profit.”
On its own website the IRS suggests many factors to help you to know the difference and whether your activities can be characterized as a “business.” These include but are not limited to:
- Do you depend on the income earned from these activities?
- Have you changed your approach or processes in order to improve profitability?
- Have you earned a profit from similar activities in the past, or reported a profit from these activities in prior reporting years?
- Does the time, focus, attention and effort you put into the activity genuinely reflect a desire and intention to turn a profit?
- Do you or your advisors have the necessary knowledge or experience to operate a successful business?
For example, if you make arts and crafts such as necklaces and earrings and spent $2,500 on tools, training, supplies and accessories but only generated $150 in sales, you will only be able to deduct $150 in business expenses or losses. The deduction cannot exceed earnings. When the IRS sees business expenses or losses on a tax return without any evidence of a genuine business enterprise or activity an IRS audit is highly likely. When the IRS declares the “business” on your return to be a “hobby” it opens you up to substantial penalties, as well as back taxes and interest.
Generally speaking the IRS will look at the level of your activities and the income they generate to determine when does a hobby become a business to allow for deductions and losses. The IRS may tolerate up to two years of losses without your “business” turning a profit. After two years you are highly likely to trigger an audit. The San Diego IRS tax attorneys at Allen Barron can help you to prepare and file tax returns and represent you in an IRS audit. If you have been contacted for an IRS audit we invite you to contact us for a free consultation at 866-631-3470.