Three Factors to Differentiate a Hobby from a Business

There are several factors that can help you determine whether to treat an activity as a hobby or business.  The difference between the two is a bit subtle, but the implications on your taxes, are quite clear.

Since even the IRS admits this matter can be a little confusing, we’ll give you three simple factors to consider to make your tax declarations easier:

  1. What do you use the extra income for? In other words, is there significant proof that you depend on the income you earn from this activity? If your answer to this question is yes, you may want to declare the activity as a business.

2. What is your behavior surrounding the hobby or business? Here, you must look at whether or not you make active efforts to make the enterprise more profitable (i.e. do you advertise your products or services), whether or not you have the knowledge or expertise to run the activity as a profitable business, and whether your administer the activity the way a business would be run.

The logic behind this factor is quite simple. Generally, an activity you do because you like it or enjoy it, without regard to the losses or profits you gain from it, is considered a hobby and not a business.

3. What is the nature of the losses you incur from the activity? Lastly, the IRS finds out if the losses you incur from the activity are a natural and necessary expense for running a business.

Because the IRS is generally strict when it comes to monitoring these things, it is helpful to seek the assistance of a professional tax accountant.

Next week, we’ll discuss the some of the differences in tax treatment between the two choices…