- Learn how to use Form 1099-K to report hobby income.
- Discover how to treat hobby expenses for tax purposes.
- Find out if hobby losses are tax deductible.
- Learn about hobby tax reporting.
- Find information regarding not-for-profit rules.
- Learn about the factors that determine whether your hobby is a business or not.
- Learn about the IRS’s trade or business presumption.
- Find information about self-employment tax.
Involved in a hobby that you not only enjoy but that produces income? If so, you may have wondered whether the income is taxable, how the tax law treats hobby-related expenses, and if a net loss is tax deductible. Also, if there’s a net profit, has your hobby now become a business?
Most individuals don’t begin a hobby intending to make money from it. But if they do, tax law says that the hobby income must be reported on their tax return. In the past, the IRS depended on the honesty of hobbyists to include their income on their tax returns. However, it was relatively easy for individuals to avoid including miscellaneous income from hobbies when their only sources of sales of their products were word-of-mouth sales, flea market sales, and such – generally cash transactions with no paper trail.
Nowadays, many individuals sell the merchandise they make as a hobby through online e-commerce sites such as Etsy, eBay, Amazon, and others. Congress decided that to rein in unreported income, these sites and third-party payers such as credit and debit card issuers, PayPal, and similar companies should report to the IRS the income received by the selling individuals each year. After a delayed implementation of the new rules, the IRS has said that starting with the tax year 2023, Form 1099-K will be used to report sales of $600 or more, regardless of the number of transactions. Hobbyists will need to make sure they include the income shown on the 1099-K on Schedule 1 of Form 1040. Otherwise, they must explain why the income isn’t taxable.
The IRS considers expenses related to a hobby as personal expenses which aren’t tax deductible. (Before changes included in the Tax Cuts and Jobs Act of 2017, hobbyists could deduct expenses up to the amount of their hobby income as a miscellaneous itemized deduction on Schedule A, but not through 2025.) Thus, hobby income is reported on Schedule 1 of the hobbyist’s 1040 and no expenses are deductible.
Some hobbyists try to get a tax deduction for their hobby expenses by treating their hobby as a trade or business. First, they disguise hobbies as a trade or business. Then, if the hobby expenses exceed the hobby income, they think they can report a deductible business loss. But the tax code includes rules that do not permit losses for not-for-profit activities such as hobbies.
Business or Hobby?
So, what distinguishes a business from a hobby? The IRS considers several factors when making the judgment. No single factor is decisive, but all must be considered together in determining whether an activity is for profit. These factors are:
(1) Does the taxpayer carry out the activity in a businesslike manner? Maintaining complete and accurate records for the activity is a definite plus for a taxpayer, as is a business plan that formally lays out the taxpayer’s goals and describes how the taxpayer realistically expects to meet those expectations.
(2) How much time and effort does the taxpayer spend on the activity? The IRS looks favorably at substantial amounts of time spent on the activity, especially if the activity has no great recreational aspects. Full-time work in another activity is not always a detriment if a taxpayer can show that the activity is regular; time spent by a qualified person hired by the taxpayer can also count in the taxpayer’s favor.
(3) Does the taxpayer depend on the activity as a source of income? This test is easiest to meet when a taxpayer has little income or capital from other sources (i.e., the taxpayer could not afford to have this operation fail).
(4) Are losses from the activity the result of sources beyond the taxpayer’s control? Losses from unforeseen circumstances like drought, disease, and fire are legitimate reasons for not making a profit. The extent of the losses during the start-up phase of a business also needs to be looked at in the context of the kind of activity involved.
(5) Has the taxpayer changed business methods in an attempt to improve profitability? The taxpayer’s efforts to turn the activity into a profit-making venture should be documented.
(6) What is the taxpayer’s expertise in the field? Extensive study of this field’s accepted business, economic, and scientific practices by the taxpayer before entering into the activity is a good sign that profit intent exists.
(7) What success has the taxpayer had in similar operations? Documentation of how the taxpayer turned a similar operation into a profit-making venture in the past is helpful.
(8) What is the possibility of profit? Even though losses might be shown for several years, the taxpayer should try to show that there is realistic hope of a good profit.
(9) Will there be a possibility of profit from asset appreciation? Although the taxpayer may not derive profit from an activity’s current operations, asset appreciation could mean that the activity will realize a large profit when the taxpayer disposes of the assets in the future. However, the appreciation argument may mean nothing without the taxpayer’s positive action to make the activity profitable in the present.
Tax Treatment of Hobbies
Because deciding to use these factors is so subjective, the IRS regulations provide that the taxpayer has a presumption of profit motive if an activity shows a profit for any three or more years during five consecutive years. However, if the activity involves breeding, training, showing, or racing horses, then the period is two out of seven consecutive years.
Making the proper determination is important because of the differences in tax treatment for hobbies versus trades or businesses. If an activity is determined to be a trade or business in which the owner materially participates, then the owner can deduct a loss on his or her tax return. It is not uncommon for a business to show a loss in the startup years.
Those with a profit who are truly operating a trade or business will usually be eligible for the Qualified Business Income (QBI) deduction (through 2025). This deduction is generally 20% of the net profit of the business. It is deductible in addition to the expenses claimed when figuring the net profit. This deduction, which is allowed without having to itemize deductions, is not permitted if the income is from a hobby.
Another concern for hobbyists? Whether or not the income they report from their hobby on their 1040 is subject to self-employment (SE) tax. The SE tax is the Social Security and Medicare tax paid by those with a trade or business operated as a sole proprietor. Partners in some types of partnerships also pay SE tax. Luckily, there is an exception for sporadic or one-shot deals and hobbies, which are not subject to self-employment tax.
Have tax questions related to your hobby activity and how the not-for-profit rules may apply. Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations to discuss your situation.