What is the difference between a business and a hobby — and why is it important?
Businesses are motivated by profit, while hobbies are about the
joy of the activity not the desire to make a profit. The distinction is important because when you have a business the expenses of the business are deductible and if the expenses exceed the income, the business’s losses are deductible against other income. Hobby expenses are only deductible up to the amount of hobby income and are only deductible for those that itemize as miscellaneous deductions. Hobby losses are never deductible.
While the IRS tends to claim that business activities that don’t make a profit at least 3 out of 5 years are hobby activities and not business activities, the real answer to what is a business as opposed to a hobby according the courts is much more complex and takes into account the following:
- Profit motive: Is the activity conducted with the intention to make a profit?
- Frequency and continuity: Is the activity operated on a regular and continuous basis?
- Expertise: Does the taxpayer have expertise in the field that suggests a business intent?
- Investment of time and effort: Does the taxpayer spend a significant amount of time and effort in the activity?
- Success in similar endeavors: Does the taxpayer have a history of success in similar business ventures?
- Profit and loss history: Does the taxpayer have consistent profitability over time? This may support the claim that the activity is a business, while continuous losses might indicate a hobby.
- Changes to improve profitability: Does the taxpayer implement changes or adjustments to enhance the activity’s profitability?
- Personal pleasure or recreation: Is the activity primarily pursued for personal enjoyment or recreation? If so, it could be a hobby.
- Time and effort spent on other income-producing activities: Does the taxpayer have another source of income and spend more time/effort on that? This might suggest the activity in question is a hobby.
It’s essential to keep thorough records and documentation to support the claim that an activity is a business. Taxpayers should be able to show that they are making a genuine effort to run the activity as a profitable business.