04 November 2015
Many people have something they do (or could do) in addition to their regular job that can make some extra money. For example, I built some Adirondack furniture for use around my home. Some friends commented that they liked the pieces, so I made them some as a gift. Not long after that I had people offering to pay me to make some chairs. While I doubt I could ever support myself making Adirondack furniture, it could turn into a little side gig where I could make some additional money doing something that I enjoy.
If I began building chairs to sell - do I have a hobby that produces income, or have I started a business?
Unless it is specifically excluded, the IRS considers income from any source (including hobbies) to be taxable. However, the IRS treats hobbies and businesses differently, and the tax advantages and disadvantages between hobbies and businesses are also quite different. The IRS has some guidelines on how to differentiate between a hobby and a business, but the bottom line is that a business is actively pursuing a profit. If your business is persistently losing money it looks more like a hobby. If your hobby is highly profitable, it looks more like a business.
Below is a table of the relative tax consequences of declaring your activities a hobby vs a business.
Let me go into some additional detail on each of those issues.
The main advantage a hobby has over a business is being exempt from self-employment taxes. Self -employment taxes are the equivalent of payroll taxes for self-employed taxpayers. These are your Social Security and Medicare taxes. Not only do you have to pay your share as the employee, but when you are self-employed you must also pay the matching share as the employer. This is no small tax, amounting to 14.13% for most self-employed taxpayers. This is in addition to your federal and state income taxes. If you live in Virginia, and your federal top marginal rate is 25%, you are looking at paying 25% (federal tax) + 5.75% (Virginia tax) + 14.13% (payroll tax) = 44.88% of your business income in taxes. If your small business earns $1,000 above expenses, you can keep $551.20. If you have a hobby you don't pay self-employment taxes and your total tax rate is 25% + 5.75% = 30.75%. If your hobby earns $1,000 you can keep $692.50.
Businesses, on the other hand, have greater latitude for deducting expenses than a hobby. This is especially true with a hobby that requires some capital investments. Take my Adirondack furniture activities, for example. Say I decide to buy a new table saw with an increased capacity enabling me to produce chairs more efficiently. Can I write that off my taxes as a hobby expense? Only to the extent that I have hobby income in that year. Plus, I have taken steps to improve the profitability of my furniture building activity - making it look less like a hobby and more like a business to the IRS.Can I have a big fancy table saw as part of a hobby? Of course, but I should be prepared to explain myself to the IRS. On the other hand, if I declare my Adirondack production activities a business I can deduct (via depreciation) the cost of my new saw and the IRS won't bat an eye.
Your hobby cannot take a loss as a tax write off, either. You can only deduct expenses up to the amount of your hobby income. If I sell my chairs and take in $1,000, but I have $2,000 in expenses, I can claim only $1,000 of the expenses. Unlike losses from passive activities, unused hobby losses cannot be carried forward to future tax years. If they cannot be taken because they exceed hobby income, they are permanently lost. Additionally, hobby losses are deducted on Schedule A as miscellaneous itemized deductions subject to the 2% of AGI floor. That means if my AGI is $50,000 I don't get credit for my hobby expenses until they exceed $1,000 (2% of $50,000). Unfortunately, you apply other deduction limits prior to the 2% limit, therefore I apply the $1,000 hobby expense limit in this scenario (limited by hobby income) and then apply the 2% of AGI limit. This sequence means that unless my hobby income exceeds 2% of my AGI I can't take any hobby deductions at all!
A business, on the other hand, can write down losses in excess of business income. Your losses on Schedule C can be used to reduce your AGI, and the taxes you have to pay on income from other sources.
The Bottom Line
For tax purposes, if your activity is making money you want it to be a hobby so you do not have to pay self-employment taxes. If your activity is losing money you want it to be a business so you can get full credit for your expenses and deductions. You don't get to just pick and choose, however. The IRS looks closely at businesses that are losing money every year to determine if there is truly a profit motive, or if the person is just improperly writing his hobby activities off his taxes as a business. Likewise, if your hobby is persistently making money in increasing amounts, you can expect the IRS to check to see if you are really running a business.
If you want help determining whether your side gig is a hobby or a business, please contact me.