Sometimes, I slay dragons. Sometimes it is by knowing the definition of a hobby.
One day, a client comes in and brings his last few years of taxes, wondering why he pays so much every year. He has a job and a side hustle. It shouldn’t be that much.
I look over his taxes and see that he is showing self-employment income. I asked him about his business. He owns a retired racehorse who is basically an expensive ‘escort’. A professional breeder sends him a 1099 each year for the fees.
That’s a hobby. For him and the horse. That’s not a business. My client has been paying double taxes because that is how DIY tax software labels 1099 income.
Tax software doesn’t ask questions or give advice. You are set up to fail if you have something different than the norm. This is one of my big reasons for explaining things for free all the time.
So, is it just a hobby?
Are you a Business?
The IRS defines a business as an “intent to make a profit” (IRS §162). That’s it. If you are doing what you do for the purpose of making money, it’s a business. If you are doing what you love and just happen to make money, it’s a hobby.
But how are money-making hobbies different than having a goal of money?
How does the IRS know? Can they read your mind? How would they know your intent?
If we go a little deeper into the law, we can look at how the IRS decides if someone is self-employed (IRS §31). One of those big factors is financial risk. If you are taking a financial risk, meaning you could lose money, then you are likely a business.
How do ‘intent’ and ‘risk’ tie together to make you a business? The biggest factor? Advertising. You are paying money that you cannot get back (risk) to sell your product or service (intent to make a profit).
If you are making business cards and advertising, whether with signs or paid advertising of any kind, and you are taking a financial risk to make a profit, you are a business, not a hobby, and are subject to business taxes
What is Hobby Income?
Hobby income is money as a result of doing something for enjoyment. If you love hunting and fishing and other people want to pay you to teach them hunting and fishing, that’s hobby income. If you love to crochet or knit or quilt and you sell off your projects to make more room in your home, that’s hobby income. If you have a purebred dog and decide to breed and sell puppies, that’s hobby income. If you are a high-level gamer and people pay you to level them up in a game, that’s hobby income. Casino gambling? Hobby income.
The IRS does not limit the amount. Hobby income generally offsets the cost of your hobby. Owning and breeding racehorses, like my client, can lead to substantial hobby income.
Hobby Taxes vs Business Taxes
Time to talk about taxes. On one hand, a business can deduct ALL the ‘ordinary and necessary’ business expenses that it cost to make the money. The phone bill, studio rental, mileage for trips to the store, all that is deducted from your business income before you pay taxes on it.
On the other hand, hobbies can only deduct the actual cost of any products you sold. Paintings: the cost of the canvas and a dollar’s worth of paint. Breeding animals: nothing, maybe a stud fee. Lessons or teaching: nothing. There are very few things you can deduct from hobby income before you pay taxes on it.
But I need two more hands.
On the third hand, business income is subject to self-employment tax. Having a business is considered work and is subject to Social Security and Medicare taxes. This is on top of income tax and figured on a completely different page on your taxes. Since you don’t have an employer matching your part, you pay double what you would pay at a job. It is nearly 15% and is figured on your business profit without regard to the rest of your tax situation. Even low-income people must pay it.
If you are a business, you may also be subject to collecting and remitting sales tax to the state and business licensing fees by your locality. It can get messy.
On the fourth and final hand, since hobby income isn’t a job or work, it isn’t subject to any additional taxes. It is taxed at the same rate as the rest of your income.
Business= more deductions + higher taxes
Hobby= few or zero deductions + lower taxes
Slaying Dragons
I was my client’s hero that day. I got him to pay much less in taxes going forward. The tax code is complex and nuanced and I am glad I can slay people’s dragons.
Don’t let tax software convince you that you are a business because you got a 1099. Hobbies are reported as “other income” on line 8z of Schedule 1, not as a business. Hobby costs go on line 24z.
As always, check with a tax professional to be sure you are complying with all applicable laws. Your state may have additional laws, so be sure to consult someone in your state.