It’s your passion, your hobby but also your business. It doesn’t matter what you call it. But does it matter to the IRS?
If you’ve got a side project or passion that’s making—or even losing—money, you need to know where the IRS draws the line. The difference can mean paying more (or less!) in taxes.
The Difference Between a Business and a Hobby When Filing Taxes
At its core, the IRS’s definition of a business boils down to one question: Are you trying to make a profit? That’s the main spirit of the IRS’s rules. If you’re not in it for profit, the IRS sees it as a hobby—and they aren’t too keen on people deducting hobby expenses from their income taxes.
For the IRS, it does matter if your activity is considered a business or a hobby. The difference is, the IRS allows businesses to deduct expenses —like supplies, equipment, and even travel— that reduce their taxable income.
With a hobby, those deductions go out the window. You can only deduct expenses up to the amount of income generated by the hobby, and even then, the rules are limited.
Key Differences Between a Business and a Hobby
Profit Motive:
Are you running this venture with the intention of making money, even if it’s not successful right now? If you’re constantly losing money year after year, the IRS may decide you’re not serious about profit and classify your activity as a hobby.
Effort and Expertise:
Are you working to make your business more profitable? Do you have the knowledge or experience to improve it? If you’re treating it like a business—tracking finances, keeping records, marketing, etc.—that works in your favor.
Sales History:
Have you made money from similar activities in the past? A history of profitability, or at least efforts to get there, can help prove you’re running a business.
Time and Energy:
How much time are you spending on this activity? A business owner puts in consistent effort, while a hobbyist dabbles. If you’re solely spending your time on your farm or rodeo circuit, the IRS might take a second look if you are claiming the activity as a hobby.
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The IRS 9-Point Test
Here is how the IRS determines whether an activity is a business or a hobby:
1. Do you keep accurate books and records for your activity?
2. Do you put in enough time and effort to indicate a profit motive?
3. Is your livelihood dependent on this income?
4. Have you made a profit in this activity in the past, or in similar activities?
5. Are your losses a result of circumstances beyond your control (such as startup costs)?
6. Do you have the knowledge or expertise to improve profitability?
7. Have you changed methods to increase profitability over time?
8. Can you expect the activity to generate a profit in future years?
9. Have you profitted in at least three of the last five years? (Or two of the last seven years for certain activities like horse breeding, training, showing, or racing.)
If you answer “yes” to several of these, you’re likely in business in the IRS’s eyes. If not, you might have a hobby on your hands.
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Common Misunderstood “Hobbies”
There are a few types of activities that often blur the line between business and hobby.
● Farms and ranches can raise red flags with the IRS if they consistently operate at a loss. If you’re raising animals or growing crops and calling it a business, you need to show that you’re actively working to make it profitable—whether through selling products or services, like boarding horses or offering farm tours.
● Rodeos are another activity that often gets scrutinized. Competing in rodeos might be a passion, but if you’re winning prize money, you need to show that you’re treating it as a business if you want to deduct related expenses. The IRS will look at whether you’re promoting yourself, training, and improving your skills to increase earnings.
● Farms, fishing operations, and livestock breeding tend to raise questions, especially if they’ve been operating at a loss for several years. The IRS may ask: Are you trying to make a living off your farm, or is it more of a weekend hobby?
The Consequences of Misclassification
If the IRS decides your activity is a hobby, the tax implications can be serious. You won’t be able to deduct expenses beyond the income you’ve made from that hobby.
In other words, if you spend $10,000 on your farm but only make $1,000 selling vegetables, you’re stuck only deducting $1,000 in expenses. The other $9,000? That’s out of pocket.
The bottom line: If you want to classify your activity as a business, act like a business owner. Keep detailed records, track your income and expenses, promote yourself, and continuously work to make a profit. Even if you’re passionate about what you do, the IRS wants to see that you’re serious about turning a profit.