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It is a common mistake to think that the IRS considers all income earned as always related to business. There are some instances in which income is considered related to a hobby and has different tax consequences.

Put simply, a business is an activity you are involved in with the purpose of making money and a hobby is not.

Here are a few easy questions that may help you determine if you have a business or hobby:

  • Do you put in enough time and effort to the activity to show a goal to make a profit?
  • Do you depend on the income from this activity?
  • If you have losses, did they occur in the start-up of the business or are they due to circumstances beyond your control?
  • Have you changed methods of operation to help improve profitability?
  • Do you or your advisors have the information needed to run this activity as a successful business?
  • Have you made a profit in similar activities in the past?
  • Does the activity make a profit in some years?
  • Can you expect to make a profit in the future from the appreciation of assets used in the activity?

If you can answer yes to most of these questions then, you most likely have a business activity and not a hobby.

The IRS assumes that an activity is a business, not a hobby, if it makes a profit during at least three of the last five tax years, including the current year. But at least two of the last seven years for activities that consist of breeding, showing, training or racing horses.

Most of the time, you can deduct ordinary and necessary expenses for use in a business. An ordinary expense is one that is common and accepted in the trade or business. A necessary expense is one that is appropriate for the business.

If an activity is considered a hobby, losses from that activity may only be used to offset income from the same source. An activity produces a loss when related expenses exceed income. The limit on hobby losses applies to individuals, partnerships, estates, trusts, and S corporations.

This is a brief overview of the rules and regulations regarding business versus hobby qualifications. For more information on determining if you have a business or a hobby, contact your accountant today!