Stop Writing Off Your Hobby as a Business
Everyone loves a good tax deduction. My own favorite loophole is the backdoor Roth IRA, which allows folks to sidestep the income limits for Roth IRA contributions (and thus potentially save a bundle in future taxes). Another common tax strategy is starting a side hustle to take advantage of business write-offs. Monetizing a hobby is a very typical path to getting a new business off the ground. But having your Etsy shop bring in a few dollars every month does not magically open the door to business deductions that will make your tax liability disappear.
Why it matters whether you have a hobby or business
The key tax consideration for the hypothetical Etsy shop, yoga studio, mechanic garage, apple orchard, etc. is whether it is a hobby or bona fide business. If you have a hobby, all gross income (before expenses) gets included on Form 1040, Schedule 1, Line 8. There is no self-employment tax because it is not a business, but your expenses are not deductible. Prior to the 2017 tax code update championed by the first Trump Administration, the miscellaneous personal itemized deduction allowed you to deduct hobby expenses to the extent of your hobby income. However, the 2017 tax code update removed that provision, making any hobby expenses not deductible.
If you have a business that is not yet formally organized in some sort of corporate form like a limited liability company (LLC), you will generally report the income and expenses on Schedule C, E, or F depending on the type of business. All gross income gets included, but then you can offset that income by expenses that are “ordinary and necessary” for your business. (No, simply registering as a travel agent does not make all your travel suddenly deductible!) In short, if you spend money in a legitimate effort to make money, you can deduct what you spend against what you bring in through your business. The net profit at the bottom of your schedule carries through to your main Form 1040 and gets included with all your other income to determine your tax liability. If it is an active business, you will also owe self-employment tax on your net profit. If your expenses exceeded your income, that loss can even partially offset your nonbusiness income.
Some folks try to play fast and loose when it comes to their side hustle by calling their hobby a business and writing off all their expenses related to that hobby. If the IRS catches wind of that, and determines that your so-called business was really a hobby, you will see all your deductions retroactively disallowed and face additional penalties for understating your income, plus late-payment penalties and interest because the additional tax gets backdated to its original due date. All these costs—none of which are deductible—can add up rather quickly!
Determining whether you have a hobby or business
Properly classifying your activity as a hobby or business avoids any surprises down the road. Showing losses year after year will lead the IRS to believe that there is no genuine effort to generate a profit. On the other hand, if you show profits three out of every five years (or two out of seven for horse-related activities), the IRS presumes you have a business rather than a hobby. Failing this test does not automatically disqualify your activity from business status, but it leaves you with a heavier burden to demonstrate that your activity is not just a hobby.
The key to properly classifying an activity is the degree to which an activity is “engaged in for profit”—i.e., how much effort you put into trying to make money. You must be “carrying on a trade or business” to unlock deductions.
Treating your activity like a business is crucial to demonstrating that you are truly trying to turn a profit rather than simply funding an activity you enjoy. Get organized properly by (1) setting up your workflow, schedule, and contacts and (2) organizing your files and finances. You do not need to formally register an LLC to have a business. Registering an LLC is an individualized decision and may be advisable once you reach a certain point, but it is not required to prove you have a business. You should, however, obtain any necessary local business licenses.
Getting organized properly is not a set-it-and-forget-it concept. You need to continuously devote sufficient time to your activity and take steps to improve. These steps might include joining a local business association, taking relevant courses to bolster skills, advertising your products and services, and periodically reviewing and revising your approach.
The extra effort sounds like a lot of work, and it is. That effort is also what separates a hobby from a business, and allows you to deduct expenses. Once you have a genuinely profitable activity, the question then becomes whether the money you make is worth all that effort.
If you are struggling to determine whether you have a business or hobby under the tax code, consider backing up and being ethically honest with yourself. Are you doing the activity entirely for enjoyment without consideration of the income stream, or have you started tracking and factoring in the income when you think about your financial situation? When your activity is close to the line between a hobby and business, your honest assessment will often be the most accurate. Honesty about your tax burden is a reliable way to live a less taxing life.
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