By James J. Newhard, CPA
People want to change jobs for many reasons: to make more money, to take control of their financial lives, to find their passion, or to simply enjoy life more. Some opt to start a business to be their own boss and control their own destiny. Many will start a business in a field where they’ve been working; others will choose to buy an existing business or buy into a franchise. If these paths don’t appeal to you because you want something you’ll truly enjoy, why not try and make a business of something you already like to do? Have you ever considered making your hobby a profession?
Start out by evaluating whether or not you can generate a revenue flow from your hobby. Be aware, though, that any income generated from a hobby must be reported on your federal income tax return. And just because an endeavor makes money, it doesn’t necessarily make it a “business.” There can be a fine line, and transition, between whether something is a business – generating revenues and permitting expenses and deductions related thereto (direct and indirect), or a mere hobby that does not permit the charging off of costs and expenses.
To qualify as a business, there needs to be a profit motive. Part of that is a state of mind, the amount of energy the taxpayer puts into developing, promoting, and working toward success. Here are some factors the IRS uses to judge whether an endeavor is a business or a hobby:
- Does the taxpayer carry on the activity in a businesslike manner, including the maintenance of complete and accurate books and records?
- Does the time and effort put into the activity indicate an intention to make a profit?
- Does the taxpayer depend on income from the activity for his or her livelihood?
- Are any losses due to circumstances beyond the taxpayer’s control?
- Are losses normal in the start-up phase of this type of business?
- Has the taxpayer adapted methods of operation in an attempt to improve profitability?
- Does the taxpayer (or taxpayer’s advisors) have the knowledge or expertise needed to carry on the activity as a successful business?
- Has the taxpayer made a profit at similar activities in the past?
- Does the activity make a profit in some years?
- Does the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
- How significant is the element of personal pleasure or recreation in the activity?
Further, if an activity is profitable in three of the last five tax years (with longer period for some ventures, like horse breeding or racing), including the current year, the presumption is that it is carried on for profit, and hobby loss limitations do not apply. (If a venture is deemed a hobby, deductions would be limited to the direct costs of the goods sold/services provided, limited to the revenues generated.)
So, intent and effort expended can make a great deal of difference regarding your taxes, and will provide a basis for deciding whether you want to jump in with both feet to make it a career. Hobbies are great, but if you need to support yourself from your efforts, the approach and evaluations are quite different.
Here are two example scenarios.
Laura goes into business selling jewelry in a multilevel marketing organization. She generally uses parts of her home to do paperwork, plan demonstrations, and store inventory. Product demonstrations usually take place in customers’ homes. Laura does not need the income and really does not care about making a profit. Laura’s sales activity is a hobby: Her intent is not to make a profit, but to cover her costs and get discounts on jewelry for herself and her friends. Further, since she doesn’t have a dedicated portion of her home used exclusively and regularly for business, she cannot claim a home office deduction.
She reports gross receipts minus the cost of goods sold on line 21, Form 1040. All other related costs are allocated to the proper category and deducted as itemized deductions on Laura’s Schedule A, but limited to the net income she reported on line 21. Expenses and costs above that net amount on line 21 are, essentially, lost.
So if Laura had sales of $6,000 and claims her cost of goods sold deduction (less amounts taken for personal use or still in her ending inventory) at $3,400, this results in a net income of $2,600 recorded on line 21 of page 1 of her federal 1040.
Remaining expenses would be claimable under miscellaneous itemized deductions as reduced (limited) by 2 percent of her total adjusted income. Laura accumulates her expenses for mileage travel and tolls, promotional or incentive gifts, advertising, postage and shipping, display cases, lighting, office supplies, training meetings and seminars, and any other expenses attributable to this venture. Suppose this totals $3,300. Laura would first be allowed to only claim a miscellaneous itemized deduction for $2,600 (the line 21 net of $2,600), and she loses the rest. Next, the 2 percent limit is applied. So, if Laura’s total page 1 adjusted gross income was $50,000, then 2 percent of that, or $1,000, is deducted from the miscellaneous deductions, resulting in $1,600 of usable deduction. The result is that Laura will pay tax on $1,000 even though her expenses exceeded all of her income.
Donna goes into the same business selling jewelry in a multilevel marketing organization. She uses a portion of her home regularly and exclusively to do paperwork, plan demonstrations, and store inventory. Product demonstrations usually take place in customers’ homes. Donna needs the income and is trying to make a profit. Donna hopes that if she can do well, this could replace her traditional office job: Her intent is to not only to make a profit, but to provide a necessary income stream that could become her main source of income.
Donna will report all income, costs, and expenses on a schedule C, the net of which will land on line 12 of her 1040, whether that’s a net profit or a net loss.
So if Donna had sales of $12,000 and claims a cost of goods sold deduction (less amounts taken for personal use or still in her ending inventory) of $6,800, this results in a gross profit of $5,200.
Donna’s home usage meets the home-office requirements, where she has 150 square feet used exclusively for this business. Claiming the simplified home-office method, she is entitled to a deduction of $750 ($5 per square foot). Donna’s business efforts resulted in her having incurred other expenses for mileage and tolls, travel (hotel and airfare to a sales conference), promotional or incentive gifts, advertising, postage and shipping, display cases, lighting, office supplies, training meetings and seminars, and other expenses attributable to this venture totaling $4,400. Accordingly, Donna winds up with net schedule C income of $50 ($5,200 gross profit, less $4,400 in business deductions, and less $750 in simplified home office deduction).
Obviously there are other nuances and tax considerations. For example, if you are relatively successful in this venture, your net business income would be subject to self-employment tax (which is the self-employed person’s version of Social Security and Medicare tax funding) as well as applicable income taxes. There may be some additional opportunities to claim a deduction for retirement contributions and/or medical benefits. Accordingly, anyone thinking about converting a hobby into a business venture should discuss it with a professional tax practitioner to determine the right financial and tax plan for you.