It’s tax time, and the Internal Revenue Service wants to know if your income and expenses are related to a business or if your activities are a hobby that is done for pleasure. When determining if activities are a hobby or a business, tax filers can check the boxes, but no single factor is decisive. The final arbiter is the IRS, which considers multiple factors to determine if someone is operating a business whose income will be taxed or expenses deducted.

If a taxpayer receives payments through payment apps such as Venmo or Square for the sale of goods or services, they may receive an IRS Form 1099-K for those transactions. These payments are often taxable income, even if they are related to a hobby and must be reported on federal tax returns. Intuit TurboTax explains Form 1099-K requirements for hobbyists. Businesses can offset taxable income reported on a 1099-K by deducting business expenses.

The IRS helps taxpayers decide if their activities are a hobby or a business by posing numerous questions:

• Is there an intent to make a profit?
• If the activity makes a profit, how much is it?
• Can the taxpayer expect to make a future profit from the appreciation of the assets used in the activity?
• Does the taxpayer depend on income from the activity for their livelihood?
• Are any losses due to circumstances beyond their control or are the losses normal for the startup phase of their type of business?
• Are operations adjusted to improve profitability?
• Is the activity carried out like a business with complete and accurate books and records kept?
• Do the taxpayer and their advisors have the knowledge needed to carry out the activity as a successful business?

The IRS allows deductions for expenses related to carrying out the activities that are in pursuit of a trade or business. Although a reasonable expectation of profit is not required, the facts and circumstances must indicate that the taxpayer entered into the activity, or continued the activity, with the objective of making a profit.

Other factors of interest to the IRS are:

• The time and effort of the taxpayer toward the business.
• The expertise and knowledge of the taxpayer and/or their advisers.
• The taxpayer’s previous history of success or failure in the type of business.
• The expenses contrasted with the expected income of the business.

Additional explanations, along with examples, can be found in the Code of Federal Regulations, part of the National Archives of the U.S. government. Taxpayers may also want to seek the counsel of an experienced tax professional, although final judgment is in the hands of the IRS.

According to the nonprofit business development organization WESST, setting up the business properly and keeping complete and accurate financial books are essential to demonstrating that activities are carried out in a businesslike matter. Keeping track of time, especially when devoted to revenue-producing activities, may demonstrate a profit motive. Internal reports that note operational and strategic changes to improve profitability may also bolster a business owner’s intent.  

While WESST does not give tax advice, the organization offers workshops and counseling to help business owners obtain the knowledge needed to start, manage, and grow a profitable business. Workshops are geared toward new and small-business skills, and personalized business counseling is customized to the specific needs of today’s entrepreneurs starting or growing a business. 

Learn more about the services offered by WESST.

This article does not constitute tax advice.