Below are some guidelines by which the IRS determines whether an activity is being pursued for profit or as a hobby:

  • Whether you have made a profit in any years since starting the business.
  • The manner in which you carry on the activity. i.e. are you consistently taking action to grow your business?
  • The expertise possessed by you in the area of your business. i.e. Are you “professional?”
  • The time and effort you expend in carrying on the activity.
  • Elements of personal pleasure or recreation included in the business.

You do not actually have to make a profit during the first few years of your business, but you do have to be able to show that you have a profit motive in order to claim any business expenses. If your business claims a net loss for too many years, or fails to meet other requirements, the IRS may classify it as a hobby, which would prevent you from claiming a loss related to the business.

Of course, if you haven’t created an appropriate structure for your hobby-based business, then that can also be a red flag in the eyes of the IRS. An LLC or LLP are often a good way to structure a profit-making venture when you are first starting out.

Some other tax considerations for hobby-inspired businesses include:

  • If you cannot show that your business is profit-driven to the satisfaction of the IRS, your deductions will be limited by the amount of income generated in the tax years before 2018 and after 2025.
  • Under tax reform, you cannot deduct any expenses in the tax years 2018 through 2025. Such hobby expenses are generally considered a miscellaneous itemized deduction subject to 2% of adjusted gross income.
  • Regardless of the year, you cannot use a loss from a hobby to offset other income, such as salary or investments.
  • If you are selling items as a business, you’ll also need to collect and report sales tax which can also substantiate your business activity.
  • If your business has not been profitable in at least three of the prior five years, the IRS will categorize your business as a hobby. If your business includes horse training, breeding or racing, this may be extended to a profit in two of the prior seven years.
  • The major consequences of a hobby classification for your business is that you won’t be able to claim losses. However, if you have expenses that you could claim as a personal expense, such as the home mortgage deduction, you can claim those expenses in full.

Treating your hobby as a freelance business may trigger an IRS audit. Keeping accurate and extensive financial records is key so that the IRS can see that your business is legitimate. A written business plan detailing your intent to make a profit can also improve the credibility of your freelance enterprise. If you need assistance with small business taxes, please give our New York City tax office a call.