You must report income to the IRS from almost all sources including hobbies. If your activity is not carried on for profit, allowable deductions cannot exceed the gross receipts for the activity. In contrast, if you’re conducting a trade or business you may deduct your ordinary and necessary expenses even if it generates a loss.
Your business could be ripe for an IRS audit if:
- Your “business” has large expenses with little or no income.
- The loss from your “business” offsets other income on your tax return and creates a large tax benefit for you.
- Every year your “business” shows a loss.
8 questions to determine if your activity is a hobby or a business
- Is your purpose to make a profit?
- Do you participate in the activity just for fun? Hobbies are not pursued for profit.
- Is the income from the activity important to your livelihood?
- Have you made changes to improve profitability?
- Do you have the knowledge needed for success in the endeavor? Will you soon be able to turn it into a profitable venture?
- Have you made a profit in a similar activity in the past? If so, you may argue that the business is in its infancy and that you succeeded in prior years.
- Does the activity make a profit in some years? An activity is presumed to be a business if it makes a profit in at least three of the last five tax years (including the current year) or at least two of the last seven years if it deals with horses.
- Do you expect to make a profit in the future from the appreciation of assets used in the activity? If so, it may indicate that your activity is a business.
IRS audits of not-for-profit-activities
If your “business” had the misfortune to be audited, the IRS would first try to determine whether you’re hiding income by conducting:
- A lifestyle analysis to compare your revenue and expenses to others with similar types of activities, licenses, household size, zip codes, itemized deductions and such to determine whether all income was reported and;
- A deposit analysis to determine whether you have unreported income and the source of funds that were used to pay the expenses.
In addition to determining whether you hid income, the IRS would decide whether you had a profit motive or not. If no profit motive, your activity would be deemed a “hobby”, which would let the IRS disallow your loss, eliminate all expenses in excess or gross revenue and require that the acceptable expenses be claimed as itemized deductions on Schedule A (Form 1040).
Types of activities that are often deemed hobbies:
- Anything to do with dogs or horses (such as breeding or racing);
- Farming or fishing activities;
- Racing activities (such as auto or motorcycle racing);
- Rentals of yachts or airplanes;
- Artists, craft sales, or photography;
- Music, dancing, acting or other entertainment activities;
- Writing (such as blogging, free-lance, books or articles);
- Direct sales and multi-level marketing activities;
- Gambling, bowling, collectibles and;
- Other activities with low gross revenue and proportionately high expenses.