For most individuals, a hobby is a great way to spend free time, and if you are fortunate, you might even make some money while enjoying your hobby. Determining whether your activity is considered a “hobby” or “legitimate business” can have an impact on your tax strategies and savings.
Before the TCJA, individuals could deduct hobby expenses to the extent of hobby income as a miscellaneous itemized deduction if itemized deductions exceeded 2% of your adjusted gross income. Unfortunately, the TCJA has suspended miscellaneous itemized deductions, removing the ability to deduct hobby expenses against your hobby income. However, if your activity can meet the definition of a legitimate business, you can deduct expenses incurred during the taxable year and possibly take a loss if the business was unable to profit.
The Internal Revenue Service (IRS) has strict rules on what constitutes a hobby and what constitutes a legitimate business. Here is its list help determine if your activity is a hobby or a business:
- Whether you carry on the activity in a businesslike manner and maintain complete and accurate books and records
- Whether the time and effort you put into the activity indicates you intend to make it profitable
- Whether you depend on income from the activity for your livelihood
- Whether your losses are due to circumstances beyond your control or are they normal in the startup phase of your type of business
- Whether you change your methods of operation in an attempt to improve profitability
- Whether you or your advisors have the knowledge needed to carry on the activity as a successful business
- Whether you were successful in making a profit in similar activities in the past
- Whether the activity makes a profit in some years and how much profit it makes
- Whether you can expect to make a future profit from the appreciation of the assets used in the activity
The IRS looks at every business on a case by case basis.
The change in tax law under the TCJA does not automatically make your hobby a legitimate business. Individuals must be careful when they assess their activity and should review the IRS regulations. If you have an activity in the gray area or unsure if it is a business or a hobby, it is recommended to draft a memo addressing the IRS determination factors and how they apply to your situation. Also, it is important to note the burden of proof lies on the taxpayer.
Understanding the difference between a business and a hobby is critical when considering the deduction of expenses. Please contact your local Blue & Co. advisor if you have any questions or for help determining if your activity is a business or a hobby.