Hobby or Business? The IRS Wants to Know

IRS gives guidelines for determining a gig’s status

The IRS lists nine things to consider when assessing if an activity is a hobby or a business: 

• 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 put into the activity demonstrate that they intend to make it profitable
• Whether they depend on income from the activity for their livelihood
• Whether any losses are due to circumstances beyond the taxpayer’s control or are normal for the start-up phase of their type of business
• Whether they change methods of operation to improve profitability
• Whether the taxpayer and their advisers have the knowledge needed to carry out the activity as a successful business
• Whether the taxpayer was successful in making a profit from similar activities in the past
• Whether the activity makes a profit in some years, and how much profit it makes
• Whether the taxpayer can expect to make a future profit from the appreciation of the assets used in the activity

CPAs say that the tax agency’s nine items are not hard-set rules of which you must meet a certain number. “Even though the IRS has these guidelines that they use to determine if an operation is a hobby or business, it all depends on the facts and circumstances, meaning how that person is running that business,” Downey explains. 

Ford agrees, noting that the IRS is evaluating each case to determine whether the taxpayer is treating the venture as a true business. “It can’t just be sort of flying by the seat of your pants,” Ford says.

Provide evidence of a business

Evidence of a true business can include using a separate bank account for the income and expenses of the gig. You want to show an intent to generate profit by creating a business plan, advertising, printing business cards and taking classes to deepen your knowledge of the activity.

Another factor is whether the taxpayer needs the income as a means of support. If they do, that can be evidence that the activity is a business. “If you are living off of the income from that business and you have losses because you’re paying all these expenses, then it’s a really, really strong position that it is a business and this is how I make my livelihood,” Downey says.

If the gig income is used for travel or other supplemental spending, that doesn’t mean it can’t be a business, according to Ford. “You want to show the IRS that it’s your intent to be profitable in that business. It’s all very subjective.” 

Keep good records

For a hobby, tracking income and expenses may be as simple as recording entries in a notebook. “Even if you take the front part of the book and write down all the income, every sale that you made, and then in the back section of the book start writing out every expense that you have — in keeping all of those receipts together in a notebook, that will be the bare minimum,” Downey says. As the venture grows, you will likely want to use a spreadsheet or software to track costs and income. “It’s just a matter of what that person is comfortable with.”

But the bottom line is to maintain accurate and clear records, especially if you want to prove your intent is to make a profit as a business. “The best way to show the IRS your intent is to have documentation,” Ford says. “It’s putting support or some documentation around what your written intention is for the business.”

Burden of proof can shift to the IRS

If a taxpayer meets the safe harbor test, which is turning a profit in three of the past five consecutive years (or two of the past seven years for horse breeding and racing), then it’s up to the IRS to demonstrate you are not operating a business.

“The burden of proof is now put on the IRS. So they would have to put resources into disproving that you’re a business,” Ford explains. “The IRS could come in and argue that it’s not, but they’d have to have the support to do it. … You’d have to be making a lot of money versus your expenses to make it worthwhile to them.”

If you have not made a profit in five years, you may need to provide proof to the IRS that your gig is a business. You can argue that you are operating a business by showing that you have a license, a business bank account and past experience in the venture and that this type of business can take a few years to make a profit, Downey suggests. “Those types of things show that this is being operated as a business.”

Maintaining documentation is crucial. “If you are running a legitimate business, don’t be afraid if you’re not making a profit, and don’t think someone’s going to hammer down on you. The number one key is keeping track of all of your income and all of your expenses to make that determination on whether it’s a hobby or not,” Downey says.