If you have a passion for jewelry making or you want to turn your hobby into a business with an Etsy shop, it’s important to understand that the IRS has specific tax rules about this type of enterprise. Essentially, the IRS is concerned that your activities are profit-driven and not merely a vehicle for taking the associated tax deductions, or “hobby losses” as the IRS calls them.
Below are some guidelines by which the IRS determines whether an activity is being pursued for profit or as a hobby:
- Whether you have made a profit in any years since starting the business.
- The manner in which you carry on the activity: i.e. are you consistently taking action to grow your business?
- The expertise possessed by you in the area of your business: are you “professional?”
- The time and effort you expend in carrying on the activity.
- Elements of personal pleasure or recreation included in the business.
You do not actually have to make a profit during the first few years of your business, but you do have to be able to show that you have a profit motive in order to claim any business expenses. 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.
Of course, if you haven’t created an appropriate structure for your hobby-based business, then that can also be a red flag in the eyes of the IRS. An LLC or LLP are often a good way to structure a profit-making venture when you are first starting out.
Some other tax considerations for hobby-inspired businesses include:
- If you cannot show that your business is profit-driven to the satisfaction of the IRS, your deductions will be limited by the amount of income generated in the tax years before 2018 and after 2025.
- Under tax reform, you cannot deduct any expenses in the tax years 2018 through 2025. Such hobby expenses are generally considered a miscellaneous itemized deduction subject to 2% of adjusted gross income.
- Regardless of the year, you cannot use a loss from a hobby to offset other income, such as salary or investments.
- If you are selling items as a business, you’ll also need to collect and report sales tax, which can also substantiate your business activity.
- If your business has not been profitable in at least three of the prior five years, the IRS will categorize your business as a hobby. If your business includes horse training, breeding or racing, this may be extended to a profit in two of the prior seven years.
- The major consequences of a hobby classification for your business is that you won’t be able to claim losses. However, if you have expenses that you could claim as a personal expense, such as the home mortgage deduction, you can claim those expenses in full.
Treating your hobby as a freelance business may trigger an IRS audit. Keeping accurate and extensive financial records is key so that the IRS can see that your business is legitimate. A written business plan detailing your intent to make a profit can also improve the credibility of your freelance enterprise — so if you want to launch your hobby-inspired business in 2020, now is the perfect time to start planning!
Jonathan Medows is a New York City based CPA who specializes in taxes and business issues for freelancers and self-employed individuals across the country. He offers a free consultation to members of Freelancer’s Union* and a monthly email newsletter covering tax, accounting and business issues to freelancers on his website, http://www.cpaforfreelancers.com— which also features a new blog, how-to articles, and a comprehensive freelance tax guide.
*Jonathan is happy to provide an initial consultation to freelancers. To qualify for a free consultation you must be a member of the Freelancers Union and mention this article upon contacting him. Please note that this offer is not available March 1 through April 18 and covers a general conversation about tax responsibilities of a freelancer and potential deductions. These meetings do not include review of self-prepared documents, review of self-prepared tax returns, or the review of the work of other preparers. The free meeting does not include the preparation or review of quantitative calculations of any sort. He is happy to provide such services but would need to charge an hourly rate for his time.