If you intend to earn a profit from engaging in your favorite hobby -- a hobby business -- you may be able to deduct your hobby-related expenses or losses from your income and lower your tax bill. But to avoid trouble, be sure your activity qualifies as a true business and pay attention to local business rules.
What is a Hobby Business?
Hobby businesses are usually run from home (renting an office would be too expensive) and are often based on semi-recreational activities near and dear to the owner, thus earning them the nickname "hobby businesses." There are as many types of hobby businesses as there are hobbies. A basement jewelry studio, a jazz band for hire, and an antique refinishing business might all qualify.
Often a person's hobby or sideline business is a labor of love rather than a reliable source of income. This is most often the case when the business owner or freelancer has other means of financial support -- such as a regular job or a working spouse -- that effectively underwrites the microbusiness.
Deducting Hobby Losses From Your Income
An unprofitable business can be a tax shelter. So if you love what you're doing (as is usually the case in a hobby business), it might make sense for you to stick with your business even though it makes little or no money.
If you have another source of income, you may be able to use the losses from your hobby business -- including your expenses and depreciation on assets you purchase -- to offset your other taxable income. Deducting these losses can not only lower the amount of income on which taxes are owed, but also drop you into a lower tax bracket.
Of course, most entrepreneurs would much prefer to make money by earning a healthy profit rather than to take tax deductions because their business is losing money. And the savings made possible by a tax shelter do not always justify continuing a marginal or losing business. But the tax savings definitely can make a difference when you're deciding whether or not it's worth it to keep spending money on your hobby.
Proving That Your Hobby Is a Business
The catch is that only bona fide businesses can deduct their losses from their other income -- you're not allowed to deduct losses from your favorite activities, only from a legitimate, profit-motivated business. If the IRS decides that you are indulging a hobby rather than trying to earn a profit, it won't allow you to deduct your business losses.
If you consistently use your business as a tax shelter, deducting your losses from your other income year after year, you'll probably attract the attention of the IRS. Make sure that the IRS will consider your endeavor a real business before you start claiming deductions for the costs of your art projects or toy car collection.
The deciding factor in determining whether a business is legitimate is whether the activity is engaged in "for profit." In other words, you must prove to the IRS that you're trying -- not necessarily succeeding -- to make a profit with your venture. The IRS uses several different criteria for deciding whether or not your business truly has a profit motive.
The "3-of-5" test. One popular test for determining profit motive is called the "3-of-5" test. If your business made a profit in any three out of the past five consecutive years, it is presumed to have a profit motive. This means that if you claim a loss for the third straight year after starting your business, you may be inviting an audit.
Other ways to prove your business is legitimate. While the IRS gives a lot of weight to the 3-of-5 test, it is not conclusive. You can use virtually any kind of evidence to show that you're trying to make money. Business cards, a well-maintained set of books, a separate business bank account, current business licenses and permits, and advertising or other marketing efforts will all help to persuade an IRS auditor that your activity really is a business.
Complying With Local Business Rules
Many cities require every local business to obtain a tax registration certificate. Technically, this rule applies to any money-making activity -- even if you don't intend to claim any federal or state tax deductions for your hobby business. Also, if you sell goods (such as homemade jewelry), your sales will be subject to state sales taxes, which means you'll have to apply for a "seller's permit."
In practice, many microbusinesses -- so tiny that the word "business" seems excessive -- might be able to fly under these agencies' radar. But be aware that, depending on your local rules, you could be penalized if you're caught doing business without the licenses or permits required by your state or local governments. These penalties may include fines and any back taxes that apply.
In addition, getting the necessary licenses and permits will help show the IRS that you really are running a business. For more information, see Nolo's Licenses & Permits section.
For detailed information on all the deductions you can claim for a home business, get Home Business Tax Deductions: Keep What You Earn, by Stephen Fishman (Nolo).