Hobby income can affect the amount paid to the IRS. Taxpayers should know whether the IRS thinks income should be classified as a business or a hobby.
In this article:
- Why Should a Taxpayer Care About How the IRS Sees Their Hobbies?
- What Is the Hobby or Business Test for the IRS?
- What Can a Taxpayer Do to Have the Income Classified as Business Revenue?
- How Much Money Can You Earn from a Hobby Before Paying Tax?
- How Should Taxpayers File Income and Expenses for Hobby Income and for Business Income?
Frequently Asked Questions About Hobby Income Taxes
Why Should a Taxpayer Care About How the IRS Sees Their Hobbies?
The simple answer? The IRS wants to pinpoint deductions in a tax return.
On a more practical level, taxpayers should have accurate hobby income information. Tax deductions depend on what the expense falls under, or else the IRS will apply not only late penalties but also failure to file penalties.
These penalties can lead to more burdensome collection actions by the IRS, like a tax levy.
Also, taxpayers may not know when their hobby income has leveled up to qualify as a business endeavor.
However, the business and hobby debate can also flip the conversation against the taxpayer: The IRS may declare that the business venture of a taxpayer is merely a hobby. Any losses and legal deductions should not show up in a tax return, which can drastically increase the tax bracket for the taxpayer.
Earning from your passion is a good thing; however, with more cash flow comes more fingers in the pie. Uncle Sam needs your help to fund peace and stability, and some hobbies may actually be a business hidden by some taxpayers.
Lastly, hobby income and business income can both directly affect the tax income bracket of a taxpayer. However, under the new Tax Cuts and Jobs Act (TCJA), hobby income after Tax Year 2017 will no longer enjoy any deductions.
On the other hand, business deductions can reduce the adjusted gross income of a taxpayer. A lower AGI means a lower income tax bracket.
Adjusted Gross Income (AGI): The result of gross income subtracted by adjustments, and leads to the tax income bracket for the taxpayer. Specifically, gross income is the sum of the amounts found on lines 7 to 22 on the Form 1040, minus all the deductions found on lines 23 to 36 of Form 1040.
It is extremely important for taxpayers to properly classify their income. To help people unsure about their hobby income, the hobby or business test by the IRS can really help.
What Is the Hobby or Business Test for the IRS?
Taxpayers can use two tests:
- The three out of five rule, where the “hobby” or business provided profits for the taxpayer.
- The “for profit” motive, where the taxpayer proves to the IRS that the financial activity (profit or loss) is the main motive, and self-satisfaction is secondary.
The First Test
The first test is pretty straightforward. If the taxpayer can prove that they can earn a profit for three out of every five years, then the expenses used for the business can lead to deductions.
For example, any hobbyist guitarist can chalk up the travel expenses for going to gigs as valid tax deductibles. However, the guitarist must prove that they have a financial history of three years profit in order to qualify using the travel expenses as valid deductibles.
Usually, the IRS automated system can be used to take a quick look over the tax return to see if the business shows a profit for at least three years. Often, when three consecutive years have passed and the taxpayer recorded only losses, the IRS immediately goes to the second test.
The three out of five rule functions as a filter, and meeting this qualification means the IRS can now consider the income and expenses as business deductibles. On the other hand, failing the first test does not mean the end of the road for tax deductibility, as the “for profit” motive test still exists.
The Second Test
The second test takes a lot more time and effort to prove. The taxpayer may fail the first test, but the second test typically carries more weight whether the taxpayer can categorize the hobby income and expenses as business deductions for a lower AGI.
For the “for profit” motive test, the taxpayer can show that:
- The activity can lead to a profit (usually the IRS wants the activity to actually pull in money). This test is crucial, since some hobbies may have expenses that are higher than revenues.
- Expenses incurred by the activity come from external factors that are not within the control of the taxpayer, or that the expenses reported are reasonable for starting businesses.
- Professionalism has a significant presence during the activity, unlike in hobbies where passion is primary.
- Time and effort by the taxpayer show that the activity is for profit, and not just for recreation.
- Continuing the activity will reasonably lead to profit.
- The activity constitutes the lion’s share of the taxpayer’s income.
- He or she has exerted effort to improve the profitability or generation of revenue.
- Parties involved in the endeavor have competence, experience, or knowledge that can reasonably lead to profit.
- The taxpayer has previous experiences or activities that led to business endeavors, especially if the previous activity is the same or similar to the current reported activity.
For the second test, the IRS usually assigns a specific IRS officer to review the tax return.
The IRS may send an amended form of your 1040 with different amounts. The taxpayer can accept or reject the amendments.
A more in-depth resource for the second test can be found in the Federal Tax Regulations.
What Can a Taxpayer Do to Have the Income Classified as Business Revenue?
The taxpayer can:
- Have good accounting records and books. Having great documentation can prove that the taxpayer takes the endeavor seriously, unlike the flippant attitude towards hobbies.
- Show activities that increase the scale of activities.
- Report having employees or independent contractors. Having a team under the taxpayer can show a for-profit motive, especially if the taxpayer pays them
- Schedule of activities that the taxpayer conforms to religiously.
- Show well-kept receipts. Documenting expenses are typical of business endeavors.
- Show government permits and licenses.
- Business plans, as well as business cards and other marketing materials.
Some activities can make the IRS suspicious. Red flags include:
- Opening and closing businesses less than three years old
- Business deductions that encompass the whole revenue of the business
- Lack of financial feasibility
- Haphazard scheduling on the part of the taxpayer
- Lack of records, especially of sales and expenses
Both these lists are not exhaustive, as most reviews by the IRS focus on a specific business or hobby with its own circumstances.
What taxpayers should review is the specifics of the two tests and assess their own situation against their parameters.
How Much Money Can You Earn from a Hobby Before Paying Tax?
Unfortunately, taxpayers no longer receive tax benefits and deductibles for hobby income. The TCJA has changed hobbies from meriting tax deductions to straight gross reportable income.
For taxpayers, this change means that hobby expenses have no bearing at all. In a nutshell, hobby income is bad, but business income is good, since business tax deductibles exist while hobby deductibles no longer affect tax returns.
How Should Taxpayers File Income and Expenses for Hobby Income and for Business Income?
All hobby income should now be reported under Line 21 as “other income” under Form 1040. Previously, hobby deductions can reach up to the whole hobby income, but that benefit is now gone.
For business income and expenses, the taxpayer fills out Line 7 to 36. Lines 7 to 22 relate to income, while 23 to 36 focuses on reportable expenses.
Recent changes to the law made hobbies no longer tax deductible, which can affect a taxpayer’s income bracket as well as their tax rate. By properly classifying which activity is a hobby and which is a business, taxpayers can make tax planning easier, avoid penalties as well as inefficiencies that can make their tax balloon.
How will you file hobby income? Do you have any questions about how the IRS views business and hobby income? Share your insights below!
If you owe back taxes, visit taxreliefcenter.org for more information on tax relief options.