Is your side hustle a hobby?
If you want more tax deductions, my advice to you is to start a business. If you want to control your financial future, start a business. If you want to make money like the rich do, building assets and legally paying little to no taxes, you guessed it!…start a business!
However, before you run to your front lawn to start your lemonade stand, there are few tax matters that you must keep in mind to successfully accomplish the tax and financial goals mentioned above. The main question that must be answered is, Does your side hustle qualify as business?
If your side hustle is claiming loss deductions, you will want to continue reading this article.
The IRS likes to claim that money-losing activities are hobbies (bad) rather than business (good). The federal income tax rules for hobbies have been anti-taxpayers for years, and now an unfavorable change enacted in the Tax Cuts and Jobs Act (“TCJA”) made things even worse for tax periods 2018 to 2025.
Today we’re going to look at what it takes to have the IRS recognize that you have a business. The only thing worse, tax wise, than having no business is having a hobby that makes you some side income.
Hobby or Business?
If you operate an unincorporated for-profit business activity that generates a net tax loss for the year, you can deduct the loss on your Form 1040. The business tax loss deduction:
- offsets taxable income from other sources;
- reduces your federal income tax bill accordingly; and
- reduces your state income tax bill too, if you have one.
However, if you must treat your money-losing activity as a not-for-profit hobby, the tax results are not good (IRC Sec. 183).
Prior to TCJA, the big question for hobby or business had to do with tax loss. The IRS determined that if you had a hobby, you couldn’t show a loss on your tax return. You could take all of the expenses to wipe out the gross sales income, but couldn’t deduct more than that. In conclusion, you could not deduct tax losses from an activity that was classified as a hobby, even if you lost your shirt.
For example, let’s say you sold $5,000 worth of garments that you had sewn, knitted and/or crocheted. Etsy is your jam! By the time you add up cost of the fabric, needles and yarn, though, you had costs of about $3,000. So you had a gross profit of $2,000. This doesn’t give you any pay for your time, but it does cover your other expenses. You then add up the cost of things like the sewing machine, computer, ISP, cell phone (for pictures) and other general costs. You ended up with a loss of $4,000.
If it’s a hobby, prior to 2018, you would be able to take a deduction up to the total of $5,000 of sales. So, no taxable gain but no taxable loss that you could write off.
If it was a business, prior to 2018, you would have been able to take the entire loss as a deduction against other income. That meant that loss of $4,000 would have saved you on taxes.
New Hobby Law in 2018
Effective 1/1/2018, you can’t take any deductions at all for hobbies. In the example we’d used before, if you had sales of $5,000, you could take deductions up to that amount.
Now, however, you can’t take any deductions. The whole $5,000 will be subject to tax. If on the other hand it was a business you would have the entire loss as a deduction against other income.
That’s why it is more important than ever that you prove you have a business, not a hobby.
Safe-Harbor Rules
Our beloved Internal Revenue Code 🙂 has two statutory rules for determining whether you have a for-profit business (IRC Sec. 183(d)):
- Your activity is presumed to be a for-profit business if it produces positive taxable income for at least three out of every five years.
- A horse racing, breeding, training, or showing activity is presumed to be a for-profit business if it produces positive taxable income in two out of every seven years.
Prove Intent to Make Profit
If you cannot qualify for one of the two safe-harbor rules above, you may still be able to treat your side hustle as a for-profit business and deduct the losses. Your focus should be to turn that hobby into a business. You must demonstrate an hones intent to make a profit (Reg. Sec. 1.183-2(b)). Here is a list of factors that can prove (or disprove) such intent:
- Conducting the activity in a business-like manner by keeping good records and searching for profit-making strategies. You can establish this by maintaining separate personal and business bank accounts, keeping records and books (bookkeeping), and acting like similar profitable, operational entities.
- The taxpayer’s expertise. You should have extensive knowledge of your profession or activity, showing that you have studied accepted business methods and sought advice from experts. If you don’t have any past business success, make sure you have a coach, mentor, advisor or consultant who does!
- The taxpayer’s time and effort in carrying out the activity. In the Audit Technique Guide (ATG) that deals with the hobby versus business question for MLMs (aka direct selling aka multi-level marketing), it’s determined that 2 nights a week and 2 weekends a month shows sufficient time and effort. It’s not engraved in stone, though, so make sure you talk to your tax pro about time and effort standards.
- An expectation that assets used in an activity, such as land, may appreciate in value. Regs. Sec. 1.183-2(b)(4) says such appreciation may be considered in lieu of current profits. This isn’t as easy to prove with some types of businesses, but if it fits – awesome!
- The taxpayer’s success in other activities. Even if your activity is currently running at a loss, it may become profitable if the taxpayer is able to convert other activities from unprofitable to profitable as he did in the past, especially in a similar business to the current activity. Again, if you don’t have the past success, make sure the people you listen to and employ do.
- The taxpayer’s history of income or losses from the activity. A long series of losses warrants consideration. Is it ever going to profitable? Past income indicates a for-profit activity.
- The history and magnitude of income and losses from the activity; occasional large profits hold more weight than more frequent small profits. The relative amounts of the profits and losses. Regs. Sec. 1.183-2(b)(7) states, “The amount of profits in relation to the amount of losses incurred, and in relation to the amount of the taxpayer’s investment and the value of the assets used in the activity, may provide useful criteria in determining the taxpayer’s intent.” However, the presumption of profit motive in Sec. 183(d) says that if an activity has gross income for three or more of the last five years that exceeds the deductions attributable to the activity, the activity generally is presumed to be for-profit. This isn’t engraved in stone. It is possible to have a legitimate business that runs a loss for many years and still is obviously a business. Think of Amazon in this case.
- The taxpayer’s financial status. If you have other substantial sources of income, it may tend to indicate that the activity is a hobby. However, if you can demonstrate that your current state of employment is tenuous, you have a better case to prove you’re trying to ramp up a business in preparation for if or when you know longer have your job.
- Whether the activity provides recreation or involves “personal motives. “This may, with other factors, indicate lack of a profit motive. If you’re doing something that is fun, it’s harder to prove it’s a business. It doesn’t mean you can’t enjoy what you’re doing, just remember that’s why the IRS has a tendency to target race cars owners and horse breeders that claim they are really businesses and not just hobbies.
Beware of the Third-Party Reporting Requirements
Starting with the 2021 tax year, 3rd party marketplaces (like eBay and Etsy) and payment sources (like Stripe, Square and PayPal) are required to issue Form 1099-Ks for any seller who sells over $600. That means they’ll be looking for all those “hobbyists” to report the income on their tax returns. Income that doesn’t have any deductions. It’s all taxable.
Remember, if you have a money-losing side hustle, business status is good for your tax and financial health.
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