As the end of the year approaches, it’s key to ensure that you keep your records up to date regarding all income and taxable revenue you are generating from any source– including hobby businesses.
Many freelancers have multiple revenue streams, some of which may involve a unique hobby they try to monetize. If this applies to you, it is important to determine if your hobby is actually a business because the IRS will require you to pay taxes on the income derived from it. If you do not meet the qualifications for a genuine business, then you cannot deduct expenses.
How does the IRS determine if you are running a business or just have a hobby? There is a nine-point checklist that they use and apply on a case-by-case basis if this determination needs to be made for tax purposes. These are outlined in the questions below.
If you are not sure where your side hustle or freelance activities land on the spectrum of a hobby vs. a business, use the questions below to help make the determination and keep in compliance with IRS guidelines. If most of your answers are yes, you are really operating a business and will have to factor that into your tax considerations.
- Do you treat your side hustle or hobby like a business? A business operates to make a profit. If that’s not your purpose, then a hobby is defined by the IRS as something you engage in for sport or recreation only.
- Are you maintaining complete books and records? This means you are treating your activities more like a business and have the need to manage your income and expenses accordingly.
- Do you advertise your side hustle? If you are marketing this activity, again, it is consistent with a business operation and not a hobby.
- Are the profits from your side hustle a primary source of income? If you have a solid income stream from your side hustle, it is considered a business in the eyes of the IRS.
- Are you investing in your hobby business to the point where you incur significant expenses beyond a typical start-up? Conversely to the point above, if you are trying to expand or better your current operation consistent with growing a business, the IRS will factor into their determination that you are operating a business.
- Have you changed methods of operation to be more profitable? Similar to the point above, if you are trying to generate more profits through sales, this will be another sign that your hobby is indeed a business.
- Do you have business expertise and hire competent business advisors? Having an accountant and tax professional to help guide you in your operations is key, along with potential other business advisors such as a lawyer or coach. This is a smart move, but it is likely to signal to the IRS that you are operating a business rather than a hobby.
- Do you have past experience with the successful operation of similar businesses? Perhaps you are a marketer who has turned what used to be a hobby of doing photos into regular gigs that generate significant income. This would cross the line between a hobby and a full-fledged business.
- Do your hobby activities create an asset that could generate future profits? Are you a writer who has created a series of children’s books that you now sell and also do seminars on? This also signals to the IRS that you have a business structure rather than a recreational pursuit.
If you have a business that has grown from a hobby, here is what you need to know about your tax obligations:
Know which hobby deductions are allowed. You are usually entitled to deduct ordinary and necessary expenses within certain limits. The typical expense is common and accepted to complete your side hustle and a necessary cost appropriate for your side hustle. An example would be if you are a writer, an ordinary expense would be a printer and paper, and a necessary cost would be a payment processing system.
Understand the limits on hobby expenses and how to deduct them. Generally, you can only deduct hobby expenses up to the amount of the hobby income. If your hobby has more expenses than revenue, you will experience a loss, and that loss cannot be deducted from other income. Itemize your expenses into three types of deductions, following the rules for each type to deduct your hobby expenses. See Publication 535 for the rules about how to claim them on Schedule A, Itemized Deductions.
Determine the extent of losses that have occurred from your side hustle. It is normal for losses to happen in a company's start-up phase. Sometimes, the losses are beyond your control due to fire or theft. However, it's also important to know if your losses have continued beyond the period, which would be necessary to bring your side hustle to a profitable status. This may create a red flag for the IRS.
Make sure to Claim profits and losses. If you aren’t trying to make a profit with your side hustle, you can’t use a loss from it to offset your income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and only S corporations. If you did make income from your side hustle, even if you didn't intend to, you must report this income on Schedule 1 Form 1040, line 8.
Now that you know the definitions of a hobby vs. a side hustle or freelance business from the IRS perspective take the time to evaluate your own freelance activities and any income from your side hustle so you can be prepared when you file your 2022 taxes in the coming months. If you are just starting out in your freelance business, check out our guide on tax considerations for freelance start-up businesses.