Which is Better for Taxes: Hobby or Business?
The title, “Which is Better for Taxes” is a trick question. Income from both is subject to tax.
Because of the profit motive, businesses tend to result in a greater amount of sustained income and therefore have more taxable income for the owner. (Also, businesses might be subject to multiple taxes, like payroll taxes, excise taxes, etc.)
But for the “hobbyist”, they do not get the advantage of a full “write-off” for the activity’s expenses. This feature which allows business owners to only pay taxes on their income minus the full amount of expenses, is much more limited for hobbies. Therefore, there could be a tax on a much higher percentage of the hobby income when compared to a business income. Tax penalties may get a different treatment by the IRS, also.
Hobby or Business – How Can You Tell the Difference?
Better for Taxes: Hobby or Business, IRS Tax Attorney (Naperville IL)
The IRS defines a hobby as “any activity that a person pursues because they enjoy it”. The definition goes on to say that in a hobby, there is no intention of making a profit.
Usually, people form and operate a business with the deliberate intention of making a profit. Sometimes people might have hobby activities that create income. Still, you have to consider other factors in determining whether that hobby has become a business.
Note: Either activity can result in a large amount of tax liability. But different strategies are used to resolve one over the other.
But in IRS audits, this could matter, a lot! For example, gambling income could be treated as either a business or a hobby. The hobby will certainly result in more income from the audit, and therefore more tax. To reduce the tax, penalty, or interest, or to make a Fresh Start, look for a tax professional who handles gambling income if you have a gambling tax liability.
Factors Use to Determine
Here are the factors that the IRS established, to determine if someone’s activity is just a hobby, or if it has evolved into a business. The determination must consider all factors, facts, and circumstances with respect to the activity. No one factor is weighed more heavily or is prioritized over another factor.
Factors Regarding the Activity’s Income
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Does the activity make a profit in some years but not others?
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How much profit does it make?
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Has the taxpayer been successful in making a profit in similar activities in the past?
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Does the taxpayer depend on income from the activity for his/her livelihood?
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Does the taxpayer have enough income from other sources to fund the activity, or must it sustain itself?
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Are there losses due to circumstances beyond the taxpayer’s control? Are those losses normal for the startup phase of their type of business?
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Does the taxpayer expect to make a future profit from growth in the value of appreciating assets used in the activity?
Factors Regarding Taxpayer’s Behavior
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Does the taxpayer carry out his/her activity in a businesslike manner?
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Does the taxpayer maintain complete and accurate books and records?
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Does the taxpayer put time and effort into the activity to show that he/she intends to make a profit?
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Does the taxpayer and his/her advisor have the knowledge needed to carry out the activity as a successful business?
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Does the taxpayer have “personal motives” for participating in activity? (For example, is it for enjoyment or relaxation?)
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Did the taxpayer make operational changes, to improve profitability?
Considering all factors, facts, and circumstances concerning the activity, if the taxpayer receives income from an activity that is carried on with no clear intention of making a profit, the activity will likely be treated (and taxed) as a hobby, and not a business.
Note: Either activity can result in a large amount of tax liability. But different strategies are used to resolve one over the other.
For example, gambling income could be treated as either a business or a hobby. To reduce the tax, penalty, or interest, or to make a Fresh Start, look for a tax professional who handles gambling income if you have a gambling tax liability.