You can earn money without being in business. Many people do this (or try to) by engaging in personal investing—for example, by earning interest on personal bank accounts or investing in stocks that pay dividends and appreciate in value over time. Activities like these—that are pursued primarily for profit but aren’t businesses—are called income-producing activities. They are neither businesses nor hobbies, and they receive their own special income tax treatment. The distinction between a business and an income-producing activity is crucial because income-producing activities generally receive less favorable tax treatment than businesses. Thus, you’ll want to avoid this classification whenever possible.
You are entitled to deduct the ordinary and necessary expenses you incur to produce income, or to manage property held for the production of income—for example, real estate rentals. (IRC Sec. 212.) This includes many of the same expenses that businesspeople are allowed to deduct. For example, a person with a real estate rental may deduct maintenance and repair costs; an investor in the stock market may deduct fees for investment advice or accounting services.
However, there are some crucial limitations on deductions for income-producing activities that do not apply to businesses, including:
No self-employment tax. One positive tax effect of having an income-producing activity instead of a business is that you don’t have to pay any self-employment tax on the income from the activity. Only people in business have to pay self-employment taxes. This is a substantial savings, because the self-employment tax is 15.3% of your net self-employment income, up to an annual ceiling amount.
When you have an income-producing activity, you don’t file an IRS Schedule C, Profit or Loss From Business, with your tax return. You don’t have a business, so that schedule doesn’t apply. Instead, you list your expenses on Schedule A, Itemized Deductions. However, if your income comes from real estate or royalties, you list your income and expenses on Schedule E, Supplemental Income and Loss. Investors who incur capital gains or losses must file Schedule D, Capital Gains and Losses.
Only individuals can deduct expenses from income-producing activities. Corporations, partnerships, and limited liability companies cannot deduct these expenses.
An income-producing activity is an activity you do primarily to earn a profit, but doesn't involve your active, continuous, and regular management or control of a business.
Personal investing is by far the most common income-producing activity. Investing means making money in ways other than running a business—for example:
What all these activities have in common is that you are not engaged in the active, continuous, and regular management or control of a business. You are passive—you put your money in somebody else’s business and hope your investment will increase in value due to their efforts, not yours. Or, you buy an item like gold and then sit and wait for it to increase in value.
Personal investing is always an income-producing activity for tax purposes, not a business. It makes no difference whether you invest from home or an outside office.
Although the most common, investing is by no means the only income-producing activity. Almost any activity can qualify if your primary motive for engaging in it is to make money but you don’t work at it enough for it to rise to the level of a business. For example, raising and selling horses or buying and selling rare coins could be income-producing activities. You must work continuously and regularly at the activity for it to be a business.