0
One of the most common business questions asked on Internet woodworking forums concerns how to turn your passion in to a profit. Frequently, participants in these discussions assume that “hobby” businesses cannot deduct expenses against income from the sales of non-professional products. The good news is that this is not true. The IRS recognizes “hobby businesses” and has specific rules, aka “hobby loss rules”, that allow for reducing your tax burden by legitimately deducting expenses against income. The only bad news is that you’ll need to keep thorough business records and apply specific techniques to deduct your expenses. Not all expenses may be taken and your expenses cannot exceed the income from your “hobby business.” But, it’s a good start and it might even eliminate any taxes due on your hobby income.
First, let’s discuss how a real business handles its taxes.
Business Taxes
A small business operating as a sole proprietorship (a business entity owned and operated by one individual) would use a Schedule C to report all income and to categorize all business expenses. The calculated profit or loss on the Schedule C would then be carried to Form 1040 Line 12. If the business makes a profit, then the amount on Line 12 is added to your total income and becomes taxable. If a loss appears on Line 12 (Form 1040), then it is subtracted from your total income and can reduce your taxes. Schedule C losses are considered an “above-the-line” because they reduce your Adjusted Gross Income (AGI), on which taxes are calculated. This can be a very powerful tool when your business doesn’t perform like you hoped.
However, there are a few catches. The IRS applies the “3 of 5 years rule” to determine whether your business is legitimate. If your business fails to make a profit in at least three out of the last five years, they may down-grade your business to a hobby activity. Hobby activities are not allowed to claim losses. So, you lose any potential tax savings from losses applied to other income. There are additional rules that be used to test whether your activity is a business or hobby. Consult a tax professional or accountant for guidance on how these rules apply to your situation.
Next, let’s discuss how a “hobby business” handles taxes.
Hobby Taxes
The IRS allows certain activities “not engaged in for profit” to apply expenses against income, according to special rules and limitations. This can be a powerful way of subsidizing your hobby through the sales of your products. It is also useful in testing whether you can make the transition to becoming a real for-profit business.
A “hobby business” cannot use a Schedule C to report income and expenses. Instead, any income is reported on Line 21 (Other income) on your Form 1040. Allowable expenses are reported on a Schedule A (Itemized Deductions) on Line 23 (Other). The total for all expenses listed in Schedule A Line 23 cannot exceed the income reported on your Form 1040 Line 21. The Schedule A deductions are considered a “below-the-line” deductions because they are listed after the AGI calculation. If you are currently not using a Schedule A to itemize your deductions and if your hobby income is trivial, you may not gain from deduction your expenses. Consult with a tax or accounting professional and have them “run the numbers” to determine your best tax situation.
There is not a “3 of 5 years rule” for hobbies. So you can take the hobby deductions in any year(s) you choose as long as you don’t claim a loss. However, just like a real business, you must declare your income and pay taxes on your profits. Additionally, you may have to pay Self Employment taxes (SE), state and local taxes, sales and use taxes, and state and local licenses and permits. The good news is that some of these other taxes and fees might be deductible against the income your hobby produces.
The purpose of this blog is to compare Business Taxes and Hobby Taxes. If you have further interest in this topic, please consult with a tax professional or accountant.
Note: This blog is intended for those working in the USA only. Other countries have different tax laws.
First, let’s discuss how a real business handles its taxes.
Business Taxes
A small business operating as a sole proprietorship (a business entity owned and operated by one individual) would use a Schedule C to report all income and to categorize all business expenses. The calculated profit or loss on the Schedule C would then be carried to Form 1040 Line 12. If the business makes a profit, then the amount on Line 12 is added to your total income and becomes taxable. If a loss appears on Line 12 (Form 1040), then it is subtracted from your total income and can reduce your taxes. Schedule C losses are considered an “above-the-line” because they reduce your Adjusted Gross Income (AGI), on which taxes are calculated. This can be a very powerful tool when your business doesn’t perform like you hoped.
However, there are a few catches. The IRS applies the “3 of 5 years rule” to determine whether your business is legitimate. If your business fails to make a profit in at least three out of the last five years, they may down-grade your business to a hobby activity. Hobby activities are not allowed to claim losses. So, you lose any potential tax savings from losses applied to other income. There are additional rules that be used to test whether your activity is a business or hobby. Consult a tax professional or accountant for guidance on how these rules apply to your situation.
Next, let’s discuss how a “hobby business” handles taxes.
Hobby Taxes
The IRS allows certain activities “not engaged in for profit” to apply expenses against income, according to special rules and limitations. This can be a powerful way of subsidizing your hobby through the sales of your products. It is also useful in testing whether you can make the transition to becoming a real for-profit business.
A “hobby business” cannot use a Schedule C to report income and expenses. Instead, any income is reported on Line 21 (Other income) on your Form 1040. Allowable expenses are reported on a Schedule A (Itemized Deductions) on Line 23 (Other). The total for all expenses listed in Schedule A Line 23 cannot exceed the income reported on your Form 1040 Line 21. The Schedule A deductions are considered a “below-the-line” deductions because they are listed after the AGI calculation. If you are currently not using a Schedule A to itemize your deductions and if your hobby income is trivial, you may not gain from deduction your expenses. Consult with a tax or accounting professional and have them “run the numbers” to determine your best tax situation.
There is not a “3 of 5 years rule” for hobbies. So you can take the hobby deductions in any year(s) you choose as long as you don’t claim a loss. However, just like a real business, you must declare your income and pay taxes on your profits. Additionally, you may have to pay Self Employment taxes (SE), state and local taxes, sales and use taxes, and state and local licenses and permits. The good news is that some of these other taxes and fees might be deductible against the income your hobby produces.
The purpose of this blog is to compare Business Taxes and Hobby Taxes. If you have further interest in this topic, please consult with a tax professional or accountant.
Note: This blog is intended for those working in the USA only. Other countries have different tax laws.
