Written by a TurboTax Expert • Reviewed by a TurboTax CPAUpdated for Tax Year 2023 • November 25, 2023 3:26 PM
OVERVIEW
If your business claims a net loss for too many years, or fails to meet other requirements, the IRS may classify it as a hobby, which would prevent you from claiming a loss related to the business. If the IRS classifies your business as a hobby, you'll have to prove that you had a valid profit motive if you want to claim those deductions.
Key Takeaways
- If your business claims a net loss for too many years, or fails to meet other requirements, the IRS may classify it as a hobby.
- If the IRS classifies your business as a hobby, it won't allow you to deduct any expenses or take any loss for it on your tax return.
- Beginning in 2018 and lasting through 2025, miscellaneous itemized deductions are no longer deductible and therefore no hobby expense is able to reduce hobby income.
- If the IRS classifies your business as a hobby, you'll have to prove that you had a valid profit motive if you want to claim those deductions.
Business or Hobby?
The Internal Revenue Service typically allows you to take a tax deduction for losses incurred in the operation of your business. However, if your business claims a net loss for too many years, or fails to meet other requirements, the IRS may classify it as a hobby, which would prevent you from claiming a loss related to the business or even claiming any expenses for the hobby due to the suspension of miscellaneous itemized deductions for tax years 2018 through 2025. If the IRS classifies your business as a hobby, you'll have to prove that you had a valid profit motive if you want to claim those deductions.
Earning a profit
The IRS expects that if you start a business, you intend to make money at it. If you don't, your business might be a hobby. To determine if your business is a hobby, the IRS looks at numerous factors, including the following:
- Do you put in the necessary time and effort to turn a profit?
- Have you made a profit in this activity in the past, or can you expect to make one in the future?
- Do you have the necessary knowledge to succeed in this field?
- Do you depend on income from this activity?
- Are your losses beyond your control?
These are just some considerations that may, or may not, apply in determining if you have a business or a hobby in the eyes of the IRS.
Practical standard for business classification
The IRS safe harbor rule is typically that if you have turned a profit in at least three of five consecutive years, the IRS will presume that you are engaged in it for profit. This may be extended to a profit in two of the prior seven years in the specific case of horse training, breeding or racing. This is, presumably, because these endeavors involve a great amount of risk.
TurboTax Tip:
If you have turned a profit in at least three of five consecutive years, the IRS typically will presume that you are engaged in it for profit. This may be extended to a profit in two of the prior seven years in the specific case of horse training, breeding, or racing.
Consequences of hobby classification
Generally, the IRS classifies your business as a hobby, it won't allow you to deduct any expenses or take any loss for it on your tax return.
If you have a hobby loss expense that you could otherwise claim as a deductible personal expense, such as the home mortgage deduction, you can claim those expenses in full.
For tax years prior to 2018, other expenses, such as advertising, wages, insurance premiums, depreciation or amortization, may also be usable as an miscellaneous itemized deduction subject to 2 percent of your adjusted gross income. However, you must have earned more total income in your hobby than the amount of all of these deductions, including your personal deductions. In that scenario, it's likely the IRS would categorize your hobby as a business anyway.
Beginning in 2018 and lasting through 2025, miscellaneous itemized deductions are no longer deductible and therefore no hobby expense is able to reduce hobby income.
Preventing your business from being classified as a hobby
Running a hobby as a business could very possibly trigger an IRS audit. If your business is legitimate, keeping accurate and extensive records could help prevent the classification of your business as a hobby.
In addition to demonstrating your professional approach to your business, records and receipts can help document your profit motive. A written business plan is often a prerequisite for indicating an intent for profit, and it can also show ways in which you are modifying your business to cope with losses.
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FAQs
Key Takeaways. If your business claims a net loss for too many years, or fails to meet other requirements, the IRS may classify it as a hobby. If the IRS classifies your business as a hobby, it won't allow you to deduct any expenses or take any loss for it on your tax return.
How do you prove your hobby is a business? ›
A business is an activity where the owner intends to yield a profit. There's a hobby or business rule of thumb called a safe harbor rule, which is delineated in Internal Revenue Code Section 183. If your activity earned a profit in three of the past five years, it may be considered a business.
At what point does a hobby become a business? ›
Based on the IRS definition, as soon as you start to profit from your hobby, you're already into the small business territory.
What qualifies as a hobby expense for tax purposes? ›
For tax purposes, a "hobby" is an activity you engage in primarily for a purpose other than to make a profit. The IRS commonly classifies inherently "fun" activities like creating art, photography, crafts, writing, antique or stamp collecting, or training and showing dogs or horses as hobbies.
How do you prove your business is not a hobby? ›
Write a business plan. Even a simple business plan can help prove that you are trying to make a profit from the activity. Consider setting your business up as a corporation, limited liability company (LLC), or partnership. These forms of business can help demonstrate that you plan to generate a profit.
What is the five hobby rule? ›
According to the five hobbies rule, you need one hobby to keep you active, one to keep you creative, one to make you money, one to build knowledge, and one to evolve your mindset! So, have you heard of this rule before?
How do I prove my hobby income? ›
If you determine you have hobby income, you will report the income on Line 8 (Other income) on Schedule 1 of Form 1040. You will report your income and expenses on Schedule C of Form 1040 if you have business income and are a sole proprietor (i.e., the only owner of an unincorporated business).
What is the hobby income limit? ›
If you earn more than $400 in a calendar year from your hobby, you should file a return and report it as self-employed income on your taxes. According to the IRS rules, you must file Schedule SE and pay self-employment tax if your net earnings from your activity are $400 or more in a single calendar year.
Do you need an EIN for a hobby? ›
You won't need to apply for an EIN—unless your business has employees or is liable for federal excise taxes—and you'll report profits and losses on your personal tax return using Schedule C.
What is the 3 hobby rule? ›
The “Three Hobbies Theory” is a concept that suggests individuals should have three different hobbies: one to make money, one to stay in shape, and one to be creative. The idea is that by engaging in these three areas, individuals can lead a balanced and fulfilling life.
You must file a return if you earn $400 or more in net earnings from your business. Net earnings equal taxable business income minus allowable business deductions.
How many years can an LLC show a loss? ›
How Many Years Can You Claim a Loss With an LLC? As an LLC, you want to be careful to try not to report losses for more than two years. Otherwise, the IRS may decide to classify your business as a hobby rather than an actual business. If this happens, you can't deduct your business expenses for tax purposes.
How does IRS distinguish between hobby and business? ›
These questions can help taxpayers decide whether they have a hobby or business: Do they carry out the activity in a businesslike manner and keep complete and accurate books and records? Does the time and effort they put into the activity show they intend to make a profit?
Which of the following factors would indicate to the IRS that an activity is a hobby rather than a business? ›
These factors are:
Whether the activity is carried out in a businesslike manner and the taxpayer maintains complete and accurate books and records. Whether the time and effort the taxpayer puts into the activity show they intend to make it profitable.
Can a hobby be an LLC? ›
Turning a hobby into an LLC is an excellent way to take a leisure activity to the next level. With enough dedication, one can make money from their hobby, and with the knowledge of the LLC system, they can use the benefits of an LLC to practice their favorite activities for lower costs.
How does the IRS treat hobby income? ›
Is hobby income taxable? The IRS requires you to report all your income; hobby income is no exception. You pay taxes on your income whether you profit from a hobby or a business. However, the key difference is that taxpayers with hobby income (not considered business income) can avoid self-employment taxes.
Do I need to register my hobby as a business? ›
You won't need to apply for an EIN—unless your business has employees or is liable for federal excise taxes—and you'll report profits and losses on your personal tax return using Schedule C.
What does the IRS consider a hobby farm? ›
The IRS defines a hobby farm as an activity that is not engaged in for profit. In contrast, commercial agriculture is a trade or business that is primarily intended to generate income. It is important to note that engaging in a hobby farm does not automatically qualify it as a business for tax purposes.
