Guide to Hobby Business Taxes

Guide to Hobby Business Taxes
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Do You Owe Business Taxes Because of a Hobby?

Hobbyist or Professional Photographer? Photo by Nicolás García/Wikimedia Commons (CC-BY-SA-2.5)

Hobby business taxes are rarely thought of when the taxpayer enjoys an after-work or weekend leisure activity. Over time, it is possible for a hobby to become a home business. For example, breeding dogs as a hobby business illustrates how a sometimes breeder – who gives away puppies to friends and family members – may cross the line to becoming a small business operator simply by advertising purebred puppies for sale. It is noteworthy that the Internal Revenue Service (IRS) expects to receive tax payments even on hobby income(1).

Are You Pursuing a Profitable Hobby or Running a Small Business?

Small business taxes are due and owing if a hobby has grown into a business venture. The IRS has devised a litmus test for taxpayers to determine where – and how – to report their income:

  1. A hobby is a fun leisure activity and income is incidental; a business is any activity undertaken with the express expectation that it will yield a profit on which the taxpayer relies for personal income.
  2. A hobby becomes a business when the taxpayer tweaks the way he pursues the activity for the reason of increased profitability. A good example is the direct sales hobby vs. business of distributing nutritional supplements. A person who pursues it as a hobby does so to help friends or family members get discounts on supplements by maintaining a dealership status, even though the products bought and sold are mostly for personal use. When the taxpayer educates himself on how to become more profitable and advertises or markets for the sake of finding more buyers, he is now engaging in a direct sales business.
  3. The IRS determines that an activity, which yields a profit for three out of five years, is more of a business than a hobby. It is noteworthy that the activity does not have to yield a profit each and every year or even in consecutive years to be considered a business.

How to Claim Hobby Expenses on Your Taxes

Small business taxes must be declared by filing a Schedule C with income tax Form 1040; hobby income merely requires a notation on line 21 of Form 1040. Write off hobby expenses on Schedule A(2) as miscellaneous expenses when itemizing deductions with a Form 1040; be aware that unless these line items add up to more than two percent of the adjusted gross income, they cannot be deducted.

Do You Have to Pay Taxes on an Online Business That Used to be a Hobby?

The short answer is ‘yes.’ If a taxpayer meets the litmus test for operating a business – as opposed to pursuing a hobby – business taxes are due and owing. A good example is the freelance writer who goes from blogging for fun to tweaking the use of keywords to drive more visitors to the site in the hopes of generating ad revenues. Another example is the freelance photographer who posts photos online but then bundles them into a portfolio, sells a few and woos potential clients for assignments.

The Advantage of Paying Hobby Business Taxes

Even though it may be a hobby, business taxes actually provide a suitable vehicle for writing off more expenses than allowed under the two percent cap. In addition, the off-years – remember: a business does not have to turn a profit each and every year – can result in sizeable tax write-offs as business losses. It may even open the door to a home office deduction. The downside of the hobby-turned-business is the self employment tax that can cut into the profits. Consulting with a tax adviser is a must for a successful tax strategy in this area.