How do we determine whether we have a business or hobby for tax purposes? Well, if you’re anything like me, you figured that if you made any money…it was a business. While that is sort of true, there is more to it than just deciding that you have a business.
In today’s episode, Janet Stelly, CPA joins me and unpacks the nine critical factors the IRS considers when determining whether you’re running a business or a hobby before sharing the essential action steps you need to take NOW to ensure you’re leveraging all of your allowable tax exemptions.
Be sure to download your free pdf to accompany this episode.
Janet Stelly is a Certified Public Accountant (CPA) with an Accounting Degree and over 30 years of experience working with financials & internal controls in the healthcare industry. She is currently an Internal Auditor for a large hospital system.
She has worked with clinical and nonclinical leaders &as well as administrative teams to make the financial side of business easy to understand. She is a mentor for Opportunity Machine and Innovate South where she meets with individual entrepreneurs and healthcare startup companies to provide guidance on the financial aspects of their businesses.
Important points from this episode
What is the difference between a hobby and a business?
According to the IRS, the goal of a business is to make money whereas the goal of a hobby is for recreation. In other words, while business owners are working to make money, hobbyists are just having fun. At first glance, that seems like a fairly insignificant difference, but there’s one crucial distinction between the two…tax exemptions.
If you have a hobby, you can still make money, but you can’t claim ANY expenses. Therefore, every dime you make is taxable.
However, if you run a business, you’re allowed to claim MULTIPLE exemptions for the things that are necessary to run your business from supplies to education…even if they’re the same things you would need for your hobby.
Suddenly, the difference becomes quite clear, and you can see just how important it is for you to be running your side hustle as a business and not as a hobby. So to ensure you’re able to claim every possible exemption, you need to know what the IRS expects to see in a business.
How does the IRS determine if you have a business or hobby for tax purposes?
There are nine different factors that the IRS looks at when determining if you are running a business or hobby for tax purposes.
But the biggest red flag is a continued loss or lack of profit for three of the last five years.
The IRS is keenly aware of the fact there are start-up costs associated with starting a business, but when you consistently show a loss and you never get “out of the red,” the IRS is probably going to audit your business to determine if it is indeed an actual business.
If during this audit, the IRS determines your business is actually a hobby, they will disallow many of the exemptions you have listed which will result in extra taxes, interest, and penalties.
9 Factors to Determine Business or Hobby for Tax Purposes
1. The manner in which the taxpayer carries on the activity
Here are six questions you need to answer for this particular factor that make it clear you are truly running a business…
- Are you keeping complete and accurate records (including receipts)?
- Are you trying to do financials? Do you have appropriate documentation for all of the things you are claiming to have spent money on.
- Do you have a business plan and is it regularly updated? Or did you just do it 5 years ago and put it in a file and never look at it again.
- Do you have different methods to improve your profitability? In other words, do you pivot & tweak how you do things in your business to be more profitable.
- Do you have business cards?
- Do you have a website?
Answering yes to many (or all) of these specific questions is going to indicate that you are in fact running a real business.
2. The expertise of the tax payer or his advisors
The IRS recognizes that not everyone is going to be an expert in every area of business. However, they want to see that you are learning, investing in resources to grow your own knowledge, and hiring experts in various fields to guide you in this journey.
So these are questions to keep in mind…
- Have you invested in & hired a CPA, an attorney, or a bookkeeper?
- Are these individuals qualified and/or credentialed in their specific field?
- Have you purchased courses to expand your knowledge base in various facets of your business?
3. The time & effort expended by the taxpayer to carry on the activity
Are you trying to sell something? If you have a business and you don’t ever try to sell anything, you aren’t going to be able to make money. And it is HIGHLY likely the IRS is going to deem what you’re doing as a hobby.
If you’re a blogger and you make money through affiliate revenue or ad income, you may not directly be selling a product, but you are creating content that aligns with brands and getting your readers to buy products based on your recommendation.
Over time, as you try selling things or suggest things for readers to buy, are you pivoting when you notice your target market isn’t interested?
- Maybe you created a course for your customers, but no one bought the course. So you survey your audience, determine they genuinely need teaching resources, and decide to open a Teachers Pay Teachers shop.
- Maybe you have a shop full of resources for teachers, but you notice your sales have dropped dramatically. After asking your customers questions, you realize they need a monthly membership with guidance on how to effectively use the products you create. So you open a membership to meet those needs.
Shifting in the direction of what your customers need and selling that “thing” is the mark of a business owner. And these are exactly what the IRS is looking for when determining whether you have a business or hobby for tax purposes.
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4. Expectation that assets used in activity may appreciate in value
These are the “big ticket” items you need to run your business. While they’re more expensive purchases up front, they will bring in more revenue than their original cost over time which means they will appreciate in value. Things like…
- Computers – to write blog posts and create TpT products
- Laser printers – to print your TpT products
- DSLR Cameras – to take high quality pictures of your products
- Podcasting equipment – to create a quality listening experience
The important thing to remember about these “high dollar” investments is they need to be directly related to your business to be considered acceptable exemptions. If you try to write off a new tractor for your online teacher business, the IRS is going to have some questions.
5. The success of the taxpayer in carrying on other similar or dissimilar activities
Don’t let this one scare you because the IRS is simply determining whether you’ve ever tried something like this before. Maybe this is your first attempt at a startup company…that is 100% fine!
You have a degree in education, you’re learning about running a business by hiring experts, and you are completing courses designed to teach you about the different aspects of your small business. These all show that you are gaining the necessary expertise to grow this business.
On the other hand, if someone has tried to start 10 different companies & every single one has failed to earn an income within four years (right under the 5 year requirement of the IRS), that’s going to be a red flag. In all likelihood, people doing this are running a scam and attempting some form of tax evasion. So the IRS is going to get to the bottom of it.
The idea here is that you are showing you will do what is necessary to make this into a legitimate and profitable venture.
6. The taxpayer’s history of income or losses with respect to the activity
Your financials are not just intended to be referenced during tax time; these invaluable records will help you make smart decisions based on observable trends in your business.
In every business, there are busy seasons and slow seasons. But by studying the trends in your specific business, you can make arrangements to buy necessary things during seasons of increased income and be more frugal during lower income seasons.
As far as the IRS is concerned, even if you’re not making much profit, they want to be able to see trends with an upward trajectory. Then you can use these monthly, quarterly, or even yearly trends to make wise decisions that will set you up for success.
7. The amount of occasional profits, if any, which are earned
There may be a lot of unprofitable times during your fiscal year, but there may be a few very prosperous times based on the completion of certain activities.
Let’s use a course launch as an example.
While you’re creating the course and preparing for the launch, your profits may be very low. You might have a few small items that people can purchase, but overall, your numbers are low.
However, once the doors to your course open and throughout the course launch, you may see exponential growth in your profit. But once the doors to your course close you will notice a substantial drop in profit. This is completely expected and explainable.
Anytime you add a new offering to your suite of resources, you can expect to see a sharp increase in profit. The important thing to remember when you think about how the IRS views your business or hobby for tax purposes is that profit will not always be steady when comparing week to week, month to month, or even quarter to quarter.
But observing trends and using that data to drive decisions is key!
8. The financial status of the taxpayer
The IRS is going to take into account how many dependents you have and whether or not you have any other income coming into your household. They want to know if this activity that you are calling a business is a full-time venture or a part-time endeavor.
Ultimately, this is another piece of the big picture puzzle that the IRS wants to put together.
9. Elements of personal pleasure or recreation
This one is likely to cause you to be nervous because, hopefully, if we have a teacher side hustle or run our own business, we enjoy what we do. The IRS doesn’t expect you to hate what you do.
However, for determining whether what you’re doing is a business or hobby for tax purposes, the IRS will take into account the amount of pleasure you receive from this activity and if it has an element of recreation attached.
Remember, the IRS isn’t basing their decision of whether you have a business or hobby for tax purposes on just one of these factors. It is the combination of answers that paints a complete picture of your business.
Action Steps to Prove You Run a Business
There are four things you need to do starting today to prove to the IRS that you are truly operating a business.
- Make a business plan and update it routinely (at least once a year)
- Set up a business banking account separate from your personal account
- Get a business credit card and only use that card for business transactions
- Learn how to keep financial records organized and well documented
The IRS gives you, as the business owner, the responsibility of burden of proof to support any entries made on the tax return. So even if another individual filed your taxes for you, you are responsible to provide any supporting documentation needed to prove why that specific purchase was necessary for your business should the IRS ask.
If you have a website and you make money as an Amazon affiliate, you want to be able to have proof on your bank statement that aligns with what Amazon reported. All documentation is helpful and consistency is key in accounting.
How to Track Your Income and Expenses the Right Way
Account for every transaction
Every transaction in your business should be accounted for whether it is income or an expense. That way when tax time comes around, you have accounted for every single thing that has come into your business and every thing that has gone out of your business.
When you file taxes as a business, your exemptions are broken down into categories. You need to make sure that anything you add to a specific category one month is added to the same category the next month because consistency is key in accounting!
So let’s look at an example.
Let’s say you purchase paper for your business and this month you put that expense under the office supplies category. Well, next month rolls around and you can’t remember which category you put it under, so you just decide to add it to the miscellaneous category.
If you have everything organized, you know that each month when you buy paper, that expense is going to be categorized as an office supply.
Create a spreadsheet
To make your life easier, start with a simple Excel spreadsheet or Google Sheet. For each month, include the date of the transaction, the dollar amount, a description, and any notes (anything else that will help provide proof). Then once you have talked to your CPA, you can determine if you need another accounting system.
Keep physical and digital receipts in folders
Because many of our transactions are completed online, it is important to have two different folders. One folder will be in your email where you keep all of your digital receipts while the other folder will house all of the physical receipts you receive from in person purchases.
It’s hard to get started with anything that is new, but if you will take the necessary time NOW to figure out what you need to do, you will be setting yourself up to thrive as a business owner.
Please share any of your takeaways from this episode by tagging me on IG @classroom_exit_strategies. I’d love to celebrate with you.