That rule is extensively misused. What it really sez is that despite apperances of being a hobby, a significant profit in 3 of 5 years is a convincing argument that it is not a hobby.
Generally, the IRS uses it vs hobby like “businesses”, mostly home based sole props. Amway, dog-breeding, bass-fishermen, and other things that people often do just for the fun of it.
Nor does the IRS “rule” your “busines is a hobby” they simply disallow the loss on your Federal taxes. This does not usually affect State sales taxes, etc.
Rand Rover is correct, but, as far as I know, if you were sincerely attempting to make a profit knitting socks and whatnot, you could treat your knitting as a business for purposes of filing federal income tax. There’s no requirement that you incorporate or set up a business address or get a license or anything else.
In Michigan, at least, a) only certain types of businesses are required to have a license, and b) the state (technically) requires payment sales and income taxes whether or not you file as a business on your federal tax return. Filing a federal Schedule C is no more difficult than filing a Form 1040. I’m not saying that a fairly big business like the OP envisions wouldn’t have some extensive paperwork involved, but simply filing as a business for tax purposes is really not all that onerous.
A fair point. Replace “you must” in my statement with “you should” or something vaguer.
I was really only joking. I just found the question intriguing, since I am someone with a gigangtic habit/hobby. My goal has always been enjoyment with a secondary goal of minimizing expense of that enjoyment. Therefore, if I can, say cover the cost of my materials, I’ve come out “ahead” since I was going to buy those materials to entertain myself with anyway.
This year, I do have to say, I’ve had a LOT of opportunity to sell things and more requests than I can honor. I’m considering starting a summer push to produce things I can sell during the holidays. It wouldn’t be that much work (because of the type of “business” it is) to keep track of expenditures while I was producing. In fact, it would be kind of stupid not to, if the plan is to sell stuff for even a meager profit.
But all of those are points that the IRS uses to determine if your Sch C is a “business” or a “hobby”. If home based businesses are required by local laws to have a “business license” the fact that you don’t argues that your Scd C is more like a hobby.
This is what I’m talking about. There’s a difference between running a business at a loss and not running it as a business at all. For example, I’ll be buying alcohol for my hypothetical nightclub. If I’m a business, I’m buying inventory and it’s a business expense. If I’m not a business, then as far as the IRS is concerned I’m buying a lot of booze for a party. That legal difference could also be the financial difference between my nightclub costing me $5000 a month and $50000 a month.
If it’s the deductions you are talking about, check out the links I posted. **Rand Rover’s **points about employee benefits and the like are also good insights.
I don’t think that’s true at all. Hobby income is taxed differently from business income (no self-employment tax, for one thing), but you can still deduct expenses up to the amount of income. That makes it very different from just buying booze for a party.
If all of your income was from the hobby (just to simplify things) and you always ran at a loss, the net effect is that you can write off 98% of the income (any amount over 2% of your net income) on Sch A (itemized deductions). After that, you still get to subtract your personal exemption before calculating tax.
To illustrate it further, here’s how $100,000 in income with $150,000 in expense looks:
As a business: 100,000 in income on Sch C, 150,000 expense on Sch C. Net income to 1040: (50,000) loss. AGI is (50,000) Subtract standard deduction and exemption for taxable income of about (59,000). No tax due.
As a hobby: 100,000 in other income on 1040 (Line 21). AGI is 100,000. Subtract itemized deductions (100,000 allowable expense less 2% of AGI) of $98,000 and personal exemption of $3,500 for taxable income of (1,500). No tax is due.
In a more complicated real-life example, it might make a bigger difference whether you run as a hobby or a business, but you can see that you’re still getting the benefit of deducting some expenses in some way.
It looks to me that the tax authorities’ concern isn’t with “running a business as a hobby” but rather with “disguising a hobby as a business”.
The concern runs both ways. If you look at the tax implications in detail, you see this:
When an activity is profitable, treating it as a business usually produces a higher tax (usually higher by about 15% of the profit because of self-employment tax).
When an activity is not profitable, treating it as a hobby usually produces a higher tax (by limiting deduction of the losses).
These are oversimplified, but true in most cases. Thus, the laws are written so that the “default” treatment of the activity produces the higher tax. If you want the treatment with the lower tax, you have the burden of proof to show the correctness of that treatment.