When taxpayers see a side hustle, the IRS may see a hobby
The difference matters, because the tax bill can be substantial. Here are the nine factors the IRS uses to determine whether a business is really a hobby.
The side hustle is a growing phenomenon.
What is it? Generally speaking, a side hustle is an activity that generates income outside of an individual’s full-time job. Or, it could be a collection of activities that individuals do to support themselves instead of a traditional full-time job.
Side hustles are a great way to generate additional income, but they can really complicate an individual’s tax situation. The tax complication comes in when individuals must determine whether their side hustle should be classified as a business or a hobby for tax purposes. While this may seem simple, it can get complex.
Misclassification can lead to taxes, penalties, and interest
Many taxpayers erroneously classify their hobbies as businesses, which often yields a better tax result because the rules for deducting business expenses are more generous. Here’s a summary of how hobby and business activities are reported on tax returns.
Getting the classification right is crucial. When the IRS reclassifies a business as a hobby on a taxpayer’s return, the taxpayer will usually owe more taxes, penalties, and interest. The IRS can also retroactively reclassify the activity as a hobby, causing balances from multiple years to pile up.
Hobby versus business: It all boils down to profit motive
Fundamentally, the difference between a business and a hobby comes down to whether the taxpayer expects to make a profit.
If the taxpayer earns a profit from the activity in three of the past five consecutive years, it’s presumed that the taxpayer has a profit motive. But taxpayers shouldn’t assume that as long as their activity earns a profit in three out of every five years, the activity is definitely a business.
Instead, this factor simply decides who has the burden of proving or disproving a profit motive:
- When the taxpayer has made a profit in three of the past five years, the IRS must prove that the taxpayer didn’t have a profit motive to reclassify the activity as a hobby.
- When the taxpayer didn’t earn a profit in three of the past five years, the taxpayer must prove to the IRS that he or she did have a profit motive to prevent the IRS from reclassifying the activity as a hobby.
Regardless of where the burden of proof lies, an inquiry from the IRS will cost a taxpayer time and money. So it’s always best to ensure proper classification at the outset.
The IRS uses nine factors to determine profit motive
To make a proper classification, the IRS uses nine factors to determine whether the taxpayer has a profit motive for the activity. For each factor, the taxpayer’s facts and circumstances must show that the taxpayer entered into or continued the activity with the expectation of profit.
Intent to earn a profit is not enough. An individual could be passionate about an activity and intend to earn a profit. But if the activity isn’t marketable, and, in reality, there’s no way to earn a profit – either because of the innate nature of the activity or the way the taxpayer is doing it – then it can’t be a business.
The IRS uses these factors as a guide to determine profit motive:
1. The manner in which the taxpayer carries on the activity.
The IRS is looking to see whether the taxpayer carried out the activity in a businesslike manner, completely and accurately maintaining books and records, like other similar profitable activities. The IRS will also examine whether the taxpayer thoughtfully chose operating methods and techniques, and/or abandoned ineffective options – all of which indicate a profit motive.
2. The expertise of the taxpayer or his or her advisor.
Taxpayers demonstrate profit motive by extensively studying accepted business, economic, or scientific practices, or consulting with experts in the activity. Conversely, if a taxpayer ignores an expert’s advice, the IRS generally sees this as lack of profit motive, unless the taxpayer can demonstrate that he or she is developing a superior or new technique.
3. The taxpayer's time and effort spent on the activity.
The IRS will consider the amount of time taxpayers spend on the activity. Limited time spent on the activity doesn’t mean the IRS will perceive a lack of profit motive if the taxpayer has hired competent and qualified individuals to carry on the activity.
4. The taxpayer's expectation that assets used in the activity may appreciate in value.
The term “profit” can mean appreciation in value of assets that the taxpayer uses in the activity, depending on the type of activity. For example, a real estate investor may hold land that he expects will appreciate in value as part of the activity.
5. The taxpayer’s success in other activities.
For activities that aren’t currently making a profit, the IRS will consider whether the taxpayer has had success in creating profit in the past from other activities.
6. The taxpayer's history of income or losses with respect to the activity.
Generally, the IRS will consider a series of profitable years in an activity to show profit motive. If a startup business loses money in the first few years (but not after a reasonable period of time), the IRS won’t see that as a lack of profit motive. The IRS also won’t draw any conclusions about profit motive from losses that occur because of factors outside the taxpayer’s control, such as a fire or flood.
7. The amount of occasional profits earned, if any.
The IRS will consider the amount of profits in relation to the amount of losses, the amount of the taxpayer's investment, and the value of the assets used in the activity. Small returns on small investments may indicate profit motive, while small returns on large investments may not.
8. The taxpayer’s income sources.
If a taxpayer doesn’t have much or any income or capital from other sources, the IRS generally considers the taxpayer to have a profit motive. If the taxpayer has substantial income from other sources, and the activity in question produces small or only occasional profits, the IRS may see it as lack of profit motive. Taxpayers who earn the majority of their income through traditional employment will face a higher bar to show profit motive than for those who don’t have other sources of regular income. Losses are suspect when the taxpayer has other means, especially in cases where the activity has elements of personal pleasure or recreation, or when the losses produce other desirable tax benefits.
9. The activity has elements of personal pleasure or recreation.
When the activity has elements of personal pleasure or recreation for the taxpayer, the IRS may perceive a lack of profit motive. If there is no personal pleasure or recreation involved for the taxpayer, the IRS will likely perceive that he or she carries out the activity only for profit.
Keep these facts in mind
When applying the nine factors to determine the proper classification for side hustles, it’s important to remember that:
- Not all factors will apply to every situation.
- No one factor determines the decision.
- The IRS may consider other factors outside of the list to make the ultimate call.
- The determination is subjective. The IRS bases its decision on the specific facts and circumstances of each taxpayer and each activity in which a taxpayer engages.
- When the IRS and taxpayers disagree on the proper classification, the U.S. Tax Court is often called on to decide. The Tax Court applies the same nine factors to determine whether the activity is a hobby or a business.
- The classification of a business may change over time, as facts and circumstances change.
Here’s an example
Five years ago, Kristen was working full-time as a manager in a retail store, earning $25,000 per year. She had always dreamed of a career selling real estate, so she got her real estate license. She wanted to first test the waters by working part-time for a local real estate company. She also enjoys making jewelry and set up a storefront with an online craft marketplace to see whether anyone would be interested in buying her pieces.
In the first two years of working part-time in real estate, Kristen incurred losses. She had trouble as a new agent attracting clients and hadn’t taken any steps to learn the profession. In year three, after taking courses in real estate and finding an experienced agent to mentor her, things began to turn around; she had only a small loss.
By year five, Kristen was earning a profit in real estate that has continued to increase each year. She reduced her management job down to part-time to allow for more time for real estate, but she couldn’t afford to completely stop working in management. Kristen hopes that in the next two years, she will be selling real estate full-time and no longer working her management job.
Even as her real estate business expanded, Kristen continued making and selling her jewelry online. She had always made a profit selling jewelry, because she could sell the pieces for more than her materials and other selling costs. However, as her real estate success has grown, she has had less time for jewelry making, so she is producing fewer pieces each year. If it were not for the stress relief she feels from creating jewelry, she probably would have stopped making it due to time constraints.
Business or hobby?
Real estate as a hobby: For Kristen, selling real estate in the first two years would properly be classified as a hobby. She incurred a loss, and while she’d taken the initiative to get her license, she hadn’t taken any steps to learn more about the profession and set herself up to be successful. She relied on her management job, where she spent most of her time, as her primary source of income. She wasn’t actively taking steps to make her real estate activity profitable.
Real estate as a business: However, in year three, Kristen took courses and found a mentor. These steps indicate a profit motive in her real estate activity. She reduced losses and demonstrated that she can earn income engaging in this activity. Starting in year three, Kristen should classify her real estate activity as a business and continue to do so, as long as she maintains her profit motive.
Jewelry making as a hobby: For Kristen, selling jewelry is properly classified as a hobby. Even though she has made a profit each year, she lacks a profit motive. She primarily makes the jewelry for the personal pleasure she derives from it, and doesn’t operate the activity on a continual basis with the goal of maintaining or increasing her profits.
As illustrated by the example, earning or failing to earn a profit alone doesn’t determine the proper classification of an activity as a business or a hobby. The determination is much more complex and depends on the facts and circumstances for each activity.
Classify it right at the beginning
It’s critical for taxpayers with a side hustle or those who are contemplating one to fully understand the ramifications of their decisions.
Taxpayers, especially those with multiple sources of income, should take care to document not only their income and expenses, but also the steps they are taking to demonstrate profit motive. Whether the activity is a business or a hobby, classifying it correctly at the beginning can avoid a potentially large tax bill.