How to turn a hobby into a business (from IRS standpoint)
It is a hobby or a business? You love what you do. Your passion has the potential to allow you to earn a some extra income. Should you turn your hobby into a business? If so how? In this article, I will explain what you need to do to turn a hobby into a business.
However before I do that, I want to make certain you understand the difference between an income producing hobby and a business. I also want to make sure that you REALLY want to convert your hobby into a business. I’ll be using the United States Internal Revenue Service’s definition of hobby and a business because it is their definition that will directly impact how much you owe Uncle Sam.
Ideally, we want to pay as few taxes as legally possible. The hobby vs. business decision will have an impact on your tax bill. If you convert your hobby into a business that meets the IRS requirements, your business also stands a better chance of succeeding.
People that love what they are doing will never work a day.
Personally, I tend to be a very passionate person that has always attempted to spend my days, doing something that I loved and that I thought that would allow me to add value to other people’s lives. Granted, when I think about how I spent 20 years as a licensed certified public accountant (CPA), I’m not so sure that I would consider preparing taxes and budgets a hobby that I loved. Well, maybe I do enjoy budgeting. While I don’t consider preparing tax returns a hobby, I do enjoy preparing a few small business tax returns for a select group of clients each year because it gives me the opportunity to learn about other types of businesses. I also enjoy visiting with the business owners.
About three years ago, I scaled back on how much time I was spending doing CPA work so that I could focus on building my real estate business here in Colorado. I also wanted to build a small diversified farm operation. I decided that I would run the farm as a business operation not a hobby.
What about you? Have you been wondering if you should turn your hobby into a business? If so, I’ll explain how to turn a hobby into a business. Although we will discuss this from IRS perspective because ultimately, your decision will have tax consequences. Yet, on a more personal level, I believe there a few things you should consider before decide if you want to turn a hobby into a business.
According to the IRS, there are “Millions of people enjoy hobbies that are also a source of income.” The IRS goes on to say that the income producing hobbies include catering to cupcake baking; crafting homemade jewelry to glassblowing.” A few years ago, I remember sitting in a photography business workshop. One of the participants was not familiar with IRS rules regarding hobbies vs businesses. I can’t remember if she occasionally photographed weddings or babies. Regardless, she was VERY offended when I suggested that her photography activities might be properly classified as a hobby rather than a business. When it comes to the IRS, you can’t call something a business just because you don’t want to call it a hobby. Hobbies can be a source of income.
Have I confused you yet? You may be asking, why isn’t an income producing hobby a business? According to the Internal Revenue Service’s rules, a hobby is not a business unless there is an intent to produce a profit.
So, if my business is really a hobby, do I have to report my hobby income to the IRS? Yes.
Is it better to be a business or a hobby? I would say that it really depends on how much you are making with your income producing hobby. If it is a very small amount, it probably isn’t going to be worth the hassle and extra paperwork to operate your hobby as a business. However, there can be tax advantages to operating your hobby as a business.
“Well, I don’t want to make any money if I have to pay taxes on it.” No one enjoys paying taxes. Yet, it can be very enjoyable if your hobby is producing enough income that it covers the expenses – thus allowing your to enjoy the hobby at no cost. Furthermore, it can be very enjoyable if you are able to make a living and do something you truly enjoy at the same time. Yes, higher levels of income will cause you to have to pay more taxes. Yet, the higher levels of income are a measure of success. You can also donate some of your income to charitable causes. So, please don’t get yourself into a habit of avoiding making money simply because you don’t want to have to pay anything to Uncle Sam. If you decide to conduct your hobby as a business, you will simply ensure that your pricing covers the cost of taxes you be required to pay.
For IRS purposes, what is a business?
A business could be defined as an income producing activity that the taxpayer engages in with the intention of making a profit. If the business does not earn a profit as a reasonable period, the business will be shut down.
The business will be shut down since it was created as a way to earn a profit. The expectation of earning a profit a critical difference between a business and a hobby.
For more information see: IRS Publication 535 – Business Expenses or an experienced CPA or tax preparer.
For IRS purposes, what is a hobby?
The IRS states that people engage in a hobby for sport or recreation. They are not trying to make a profit. They are willing to engage in a hobby even if they are losing money.
For more information see: IRS Newsletter
Before we get talk about how to turn your hobby into a business, lets think about do you really want your hobby to be a business?
Do you REALLY want your hobby to become a business?
Ever since I was a young girl, I loved learning about different businesses. I always planned to own a business doing something that I loved. This was because my Dad spent his time working in a job that met his needs. He didn’t love his job. It was simply a job. Granted, my Dad never wanted to run his own business. He valued having a safe and secure job that allowed him to know when he was getting paid. He valued the benefits and the retirement plan. When I was a baby, he had a mechanic shop for a while. My Dad is a great mechanic. He could fix almost anything – motorcycles, cars, tractors, ATV’s, lawn mowers, etc. Not that he talked about it much, but I remember him saying that he didn’t want to HAVE to work on cars for other people. He felt that mechanizing for other people took the pleasure out of a hobby that he enjoyed.
Will you enjoy sharing the time spent on your hobby with other people?
If you turn a hobby into a business, how will you handle the people aspect of your business? Or the sales aspect? Many hobbies are enjoyable because they allow quiet time to yourself. Some hobbies allow you to express yourself artistically. How will you feel if you can’t do your hobby just to please yourself. What happens if you start having to do it for other people, they way the want? Will you still enjoy it?
I have a number of friends that are artists and photographers. Most are very talented. Most also would love to be able to sell some of their artwork. Yet, that goal isn’t always nice as it sounds. For example, my mom was a very talented painter. Once she took a few art classes, her talent blossomed. Before long, she had enough paintings to take to an art fair. I can’t remember is she sold out or almost sold out. So by popular demand, she started accepting commission work. She would take someone’s photograph and turn it into an oil painting, minus electrical lines or whatever they wanted to be removed. Although she was blessed to be able to turn her hobby into a profitable work at home business, she got burnt out within a year. Unfortunately, she quit painting. That was over 30 years ago and she hasn’t been able to make herself want to paint again. When she turned her hobby into a business, she ended up hating something that she once enjoyed.
Despite, my parents bad experiences, I’ve always enjoyed owning and operating my own small businesses. The lack of a steady paycheck doesn’t bother me – well, the majority of the time. I’d rather be doing something that I love than to simply be content with a steady paycheck. I also truly enjoy helping and serving people. I view my businesses as a way to share my hobby in a way that will help other people or benefit other people.
What about you?
Will you enjoy our hobby if you HAVE to do it?
Will you enjoy your hobby if you need to do it for other people, in the manner they want you to do it?
If you can answer, “yes” or “I think so” then go on. If not, maybe you should simply enjoy your hobby as a hobby.
How large would you like your hobby/business to become?
“Begin with the end in mind”
–Stephen R. Covey
In his book, The 7 Habits of Highly Effective People, Stephen Covey reminds of the importance to begin with the end in mind. In other words, we need to plan. We need to think about how much income we want to earn from our business. That in turn should allow us to figure out how big the business needs to grow in order to generate the desired long term income.
Realistically, you might want to keep your hobby turned business small.
For example, I enjoy owning and taking care of a variety of different types of chickens. I think birds are beautiful creatures. I enjoy having different breeds. Sometimes they do things that makes me laugh. For example, I think chickens look funny when they run. At the same time, I enjoy being able to provide healthy, fresh, free-range chicken eggs to people that don’t have chickens of their own. I sell roosters as meat birds.
I run my chicken operation as a business. My sales cover the expenses and I have a little bit of profit left over. Yet, I doubt that I will ever scale the chicken operation to the size that I could make a full time living off the chickens. I can enjoy several hundred birds. Yet, I do not think I would enjoy owning thousands of chickens. To me, it seems like operations that run thousands of chickens are almost industrial like. I seriously doubt that the owners or the workers are able to enjoy their birds the same way I enjoy mine. I choose to keep my business small.
The same is true for my pig operation. A few pigs are great. The pigs are my favorite farm animal. I love their personalities. Their piginess is adorable although they do seem to fart more than any other animal that I’ve had. Yet, the large hog farms keep thousands of pigs in a building. Well, I would not ‘t enjoy taking care of that many. If I had a thousand pigs, which would still be small, I couldn’t provide them the type of home that my current pigs enjoy. Thousands of pigs are just too many. As result, I know that I will have to keep my farm operation small since I’m not willing to do what is required to scale the business to a larger size.
Keeping your business small does not make it any less of a business. A small business may be much more rewarding and it may allow you to enjoy the reason why the activity appealed to you in the first place.
How much income does a small business need to make to be classified as a business for tax purposes?
To answer simply, your business needs to become profitable. The business income needs to start exceeding your business expenses within a reasonable period. Business owners are in business to earn a profit. If they can’t, most business owners will close the business. The IRS believes that if a person does not stop operating a business that is losing money year after year, they are not concerned about losing money. Therefore, the business is essentially a hobby. The IRS does not allow hobby losses to be used to reduce taxable income. On the other hand, business losses are allowed to be used to reduce taxable income. Thus… the IRS cares a lot about whether a hobby is a hobby or a business.
Why would you want your hobby to be classified as a business for tax purposes?
If your hobby can be classified as a business for IRS tax purposes, you have an opportunity to reduce your taxable income by deducting items that would qualify as a business expense. You would also have the opportunity to reduce your taxable income even on years when you have a loss rather than a profit.
Legally, money from sales or services relating to your hobby is taxable as income regardless whether your are conducting the hobby as a business or not. Hobby losses are not deductible. Most people prefer to not pay any more taxes than they are legally required to pay. Thus, it can be very advantageous if you are earning any money from your hobby if you can treat the hobby as a business.
How do I turn my hobby into a business?
The IRS considers a variety of factors to determine if someone is conducting their income producing activity as a business vs a hobby. As you read these, it may be helpful to remember that the IRS is interested in collecting as much tax as possible. So they want you to earn money. Yet, they are very picky about what type of expenses you report because expenses reduce your profit and therefore the amount of taxes they collect. Business owners can deduct more expenses than people that are involved in a hobby. That is why the IRS wants to see the intent to earn a profit.
Short answer: Do what is necessary to earn a profit. Keep good records. If you can’t earn a profit in a reasonable amount of time, close the business down.
If you want to have a business rather than a hobby, you must:
- Carry on the activity in a businesslike manner
- Maintain complete and accurate records, income and expenses.
- Ensure that you have the knowledge needed to carry on the activity as a successful business. If not, you need to find advisers that have that knowledge.
- Put in enough time and effort to allow it to become it profitable.
- Ensure that you are not incurring start up expenses out of the ordinary for your type of business.
- Change your methods of operation in an attempt to improve profitability if necessary.
- Have a written business plan. It doesn’t have to be extremely formal. Yet it should show when profitability is forecast. It should also show whether you can expect to profit from appreciation of any assets used in the activity.
- Understand that you might encounter circumstances beyond your control that will cause you to be unable to earn a profit. For example, if you are unable to earn a profit in a year that your really needed to show one because of a wild fire, a blizzard, or a major car accident that destroys your inventory – the IRS auditors will understand that you will most likely show a loss.
Basically, you need to ensure that you are doing everything possible to operate a profitable business.
If you are not willing to put in the required time or you are not willing to keep the required records, you are most likely are conducting your activity as a hobby for your personal enjoyment. There is nothing wrong with having hobbies that produce some income.
For more information see:
For more information see: IRS Publication 535 – Business Expenses or a CPA or tax preparer that is experienced doing tax returns for small businesses.
Can you earn money from a hobby and it NOT be classified as business?
Sure. However, the money you earn is still taxable. If you keep copies of your receipts, you can deduct the expenses from the money you earned. With a business, you want to keep as much of your profit as possible. If you don’t show a profit, you don’t plan to stay in business. With a hobby, your would rather enjoy your free time instead of trying to minimize the amount of taxes that you owe. With a hobby, you are willing to keep doing it even if you have a loss.
Please be aware, eveyone’s overall tax situation is different. It is always recommended that you speak to a qualified tax adviser about your particular situation.
That said, here is a simple example showing the different tax treatments for a hobby income: In this example, lets say that you are selling some pieces of repurposed furniture that you bought from a garage sale.
Sales – $1,000
Expenses include the original cost that you paid for the tables, sandpaper, paint, varnish and antique booth fees totaling $500.
Your reportable hobby income would be $500. ($1,000 – $500)
Let’s say you had the same expenses, but your sales revenue was only $500
Your reportable net hobby income would be zero. ($500 sales – $500 expenses.)
Lets assume this was your first year selling the repurposed furniture. Your sales did not cover your expenses. In other words, let us assume that you lost money.
Difference is a loss of $200. ($300 sales less $500 expenses)
Reportable hobby income = zero
However, if your hobby were a business, reported on Schedule C – your reportable income would be the ($200) loss. This loss would reduce your overall taxable income. In turn, this loss would reduce the overall taxes that you have to pay for the year. Not by much, but it would reduce the taxes. The actual amount will depend on your filing status and tax bracket.
Are you starting to see why it is best if your hobby can be classified as a business?
If you want to turn your hobby into a business, you need to operate your business in a way that shows that your are engaged in an activity with the intent to earn a profit.
Try to operate your business as if that is the only source of income that you will have to pay your bills. If you do that, you will automatically be looking for ways to increase income and reduce expenses.
If you or your family has a sizable income from a job or other business, try to operate your activity in a way that will require the activity or hobby to pay for itself. If you do that, you should be able to show that you are running a business vs enjoying a hobby.
If you have any questions, feel free to ask in the comment section below or send me an email.
I hope that you dare to spend your time doing what you love rather than just working.