Money Matters: Business or Hobby?

Is My Hobby Really A Business?

“Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit.” (IRS Pub FS-2007-18, April 2007)

You have been crocheting blankets for years. It is a relaxing activity that you really enjoy. People have offered to pay you to make one for them. You think, “Why not?”

Do you intend to start making blankets (or other items) for a profit? Or, do you just want to have your friends reimburse you for the cost of the materials? If you don’t intend to make a profit from your sales then you are engaging in a hobby. End of discussion. If you DO intend to really start making some money from this talent, you have the opportunity to start deducting your business expenses from your tax return.

Take the 3-of-5 Test:

But you will need to convince the IRS that your activity is really intended to make money. One way you can do that is with the “3-of-5” test. Has your activity earned you a profit in three of the last five consecutive years? If yes, then you are showing that you have a profit motive. If you show a loss for three consecutive years, you may be inviting an audit and may need to come up with more proof that you are at least trying. Make sure to keep good records of all of your expenses and income. Business cards, a separate bank account for business activity and advertising efforts will all work in your favor when trying to persuade the IRS that you are serious about your business. Another way to prove to the auditor that you are have a real business is to keep current on licenses or permits appropriate for where you live and/or operate the business. In our example of the crochet business, you will need to collect, report and pay state sales tax. Make sure to get a state resale ID number and follow the local rules.

The Difference Between an Ordinary Expense vs. a Necessary Expense:

The IRS says, “In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business. An ordinary expense is an expense that is common and accepted in the taxpayer’s trade or business. A necessary expense is one that is appropriate for the business.” (IRS Pub FS-2007-18, April 2007) You will even be able to deduct overall business losses in the years that you don’t make a profit.

Next Time: Business Bookkeeping for Your Home-Based Business

Photo courtesy of Flickr: https://www.flickr.com/photos/29374875@N05/3265828582/sizes/z/in/photostream/

The woman who made these adorable crochet food (see photo above) did make her hobby into a business! Her items can be found at www.skymagenta.etsy.com