Is it a Business, or is it a Hobby?

How many of you out there make really good homemade hummus? I’m typing with one hand, while I raise the other. My wife thinks that it’s better than the pre-made store bought stuff, and that I should sell it to the public. For all my clients, no, I’m not quitting my day job (yet, haha!). Aside from figuring out a catchy name for it (JayTheCPA’s hummus doesn’t quite roll off the tongue), could I really make a go of this as a business, or is it really just a hobby?

If you’ve been doing some sort of activity that you love to do (baking cakes for friends, for example), is this something that you can deduct the expenses for, and reduce your taxes? I’ll give you a big resounding maybe!

IRS has various rules to determine whether an activity is a bona fide business, or just a hobby. If an activity is an actual business, for a sole proprietor the income and expenses are shown on Schedule C, as part of your individual income tax return, and if your expenses exceed your income, the resulting loss can offset other income items on your tax return. If the activity is a hobby, expenses can only be deducted to the extent of income, so if you have no income, you can’t deduct any expenses. If you do have income, the expenses are deducted as a miscellaneous itemized deduction, subject to a floor/deductible/”haircut” of 2% of your adjusted gross income. The bottom line is that if you’ve got a hobby, you’re probably not going to get much of a tax deduction for it, if at all.

So how do you know whether your activity is a business or a hobby? Here are a few of IRS’s factors for determining the answer:

1-how is the activity carried on – IRS will look at whether the activity is being conducted in a businesslike manner. Is there a separate bank account? Are books and records being kept?

2-what is the individual’s expertise – there should be extensive knowledge of the activity, potentially showing that advice has been sought from experts.

3-time and effort on the activity – if you have a full time job and pursue the activity an hour a week, it may indicate that this is not a serious business activity for you.

4-history of income or losses from the activity – while you may be able to get away with showing a loss on Schedule C for a year or two, showing losses year after year would indicate that there’s no real profit motive for the activity, in which case IRS will deem the activity a hobby, and disallow previous losses claimed.

IRS looks at a number of other factors when making a determination of whether an activity is a business or a hobby. At this point, my hummus making (and other culinary adventures) is strictly a hobby, so I’ll keep IRS out of what’s left of my hair, and will leave the expenses off my tax return. Before you start taking deductions for your hobby, contact your friendly neighborhood CPA for advice. Do you have any interesting tax stories regarding hobbies? Please share.