Tax Breaks: Turn Your Hobby into a Business

Hobby expenses are no longer deductible...but business expenses are

Woman using sculpting tools on a sculpture as she thinks about turning it into a business

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In a perfect world, we’d all make our incomes doing something we love. Whether it’s breeding puppies, making kites, or coaching young athletes, there’s nothing quite like collecting a paycheck for doing something you’d do anyway just for the pure enjoyment of it. It’s a nice arrangement, even if you’re picking up a few dollars on the side.

But as far as the IRS is concerned, every dime you collect is taxable income. The federal tax code used to allow you to take a deduction for your hobby costs, but the new 2018 tax law changed that. Now you can only take deductions if you turn your hobby into a business.

When Your Enterprise Is Hobby

The best you could do before the Tax Cuts and Jobs Act (TCJA) went into effect was deduct costs up to the amount of money you earned from your hobby. Maybe you sold your purebred puppies for $6,000, but it cost you $7,500 in breeding fees, veterinary bills, and other necessities to produce those cute little babies. Your deduction was limited to the $6,000 you earned, and the additional $1,500 was left on the table. It couldn't help your tax situation.

And you could only deduct a portion of that $6,000 because then another rule kicked in: Your deduction was limited to the portion that exceeded 2% of your adjusted gross income (AGI). Two percent would work out to $1,200 if your AGI were $60,000 that year. So now you had to reduce further that $6,000 by subtracting this amount. You would have been left with a deduction of $4,800 after all these calculations. 

Then, beginning in 2018, the TCJA eliminated the hobby expense deduction. Now you must claim all your hobby income without getting any corresponding tax break at all. 

Tax Breaks When Your Hobby Is a Business 

At the end of the day, it all comes down to how you treat your hobby. The IRS defines a hobby as something you do for pleasure without expecting to earn a profit. You’d do it regardless of whether it ever kicked off any income.

So what happens if you change that mindset? Your income becomes eligible for much better tax treatment. 

You can claim those expenses on Schedule C—the tax form that calculates net taxable income for sole proprietors, independent contractors, and some business owners—if you treat your hobby as a business. This method means that you don’t have to worry about that 2% rule you would have dealt with in tax years before 2018. And you can show a loss on Schedule C.

In the case of those $6,000 puppies and $7,500 in expenses, you can use the difference of $1,500 to offset your other income, such as from a regular job. Just like that, you’ve reduced your overall tax bill doing something you love.

But it gets better. You’re not limited to deducting just those breeding fees and vet bills. You can deduct a portion of your mortgage and utilities if you use part of your home solely to deal with the administrative duties of running your business. You can deduct travel expenses and mileage related to doing business. In fact, you can deduct all “necessary” and “ordinary” expenses incurred when you reclassify that hobby of yours into a money-making enterprise. 

So How Do You Turn a Hobby into a Business?

You can’t simply tell the IRS, “OK, this is a business now,” and be done with it. Your activities must reflect your new mindset.

You must demonstrate to the IRS that you’re breeding those puppies because you fully expect to earn a profit from doing so. This requirement means one of two things: You have indeed made a profit from your pursuit in at least three of the last five years, or you can pass the IRS “factors and circumstance” test. In other words, you might not have turned a profit yet, but the IRS will agree that you’re indeed running a business when it looks at the big picture. 

The IRS will look at several factors when creating that big business picture. They will consider if you keep detailed and accurate financial records. You might want to establish a separate bank account for your endeavor, and do not allow any overlap between business and personal expenses. Don’t make your car payment from the business account. It’s OK to pay yourself weekly or monthly—in fact, this is a good thing because it shows that you depend on the money you’re earning to pay your bills—but the line between your expenses and business expenses should be black, not gray. 

The IRS will review if you have the training, education, knowledge, or skill to make your endeavor profitable. If you don’t, you’ve hired or are consulting with someone who does have the necessary know-how.  

Also considered is if you depend on the income from your enterprise for at least a portion of your livelihood. You will have to show you devote a fairly substantial amount of time to it. This requirement doesn’t mean you have to quit your day job, but be prepared to burn a fair amount of midnight oil and sacrifice your weekends. 

Other expenses the IRS looks at include if you spend money on things like advertising and promotion, and to attend conferences, trade shows, and other networking activities. 

Finally, they will see if you’ve made tweaks and changes to your operation to turn those losses into profits. 

The IRS doesn’t expect you to earn a profit right out of the box. It’s understandable if you suffer a loss for a year or two—many startups and new businesses do. But if you at least come close to covering your expenses, that can be a good indicator that you’re indeed operating intending to earn a profit. 

And, of course, if you incorporate or take steps to form some other business structure such as an LLC, that’s even better. Consider putting together a formal business plan, too, even if you decide to operate as a sole proprietor.

Pay the Appropriate Taxes 

Filing Schedule C because you’re now running a business isn’t all sunshine and lollipops. It comes with an additional responsibility or two. 

First, you’ll have to pay self-employment tax on this income—Social Security and Medicare. Yes, you pay these taxes as an employee, too, but in that case, you would only pay half, and your employer would contribute the other half. You’re considered to be both employer and employee when you’re running a business, so you have to pay both halves yourself. The IRS at least lets you take a deduction for half these taxes when you file your tax return.

The IRS doesn’t want to wait until you file your tax return to begin collecting taxes from you, either. You must pay your estimated income taxes and self-employment taxes quarterly as the year goes on. Otherwise, you’ll end up paying interest and possibly penalties. 

What If the IRS Asks for Proof? 

The need for keeping meticulous records can’t be overstated. A lot more taxpayers can be expected to make this transition in 2018 now that hobby expenses are no longer deductible so that the IRS will be keeping a close eye on this situation going forward. 

Be ready to prove that you mean business. 

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