Key Differences Between a Business and a Hobby

1. For-Profit Business
   
• Taxpayers operating a business for profit can deduct ordinary and necessary expenses.
• Losses exceeding income can be deducted to offset other income.
2. Hobby
   
• Hobby income must be reported on Schedule 1 (Form 1040), but deductions are limited to the cost of goods sold (COGS).
• Expenses beyond COGS cannot be deducted, and losses cannot offset other income.

IRS Factors for Determining Profit Motive

The IRS evaluates the following factors to determine if an activity is conducted for profit:

• Businesslike Operations: Keeping accurate records and improving profitability can indicate a profit motive.
• Expertise and Preparation: Consulting experts or extensive preparation may demonstrate intent to profit.
• Time and Effort: Significant personal time or hiring qualified individuals can signal a business.
• Asset Appreciation: Expecting assets like land to appreciate can qualify as a profit-oriented activity.
• History of Income or Losses: Initial losses may be acceptable, but persistent losses without profit can suggest a hobby.
• Occasional Profits: Even small profits in speculative ventures may indicate a business intent.
• Personal Pleasure: Enjoyment of the activity does not preclude it being a business if profitability is evident.

Activities Commonly Identified as Hobbies

The IRS often scrutinizes certain activities, including:

• Craft sales, photography, dog breeding, horse racing, writing, and yacht charters.
• Activities producing frequent losses may trigger IRS investigations into their profit motive.

Presumption of Profit

An activity is presumed to be for profit if it generates a profit in three of the last five tax years (two of the last seven for horse-related activities). If the presumption is met, hobby loss limitations do not apply.

Tax Reporting for Hobbies

• Income: Report gross income (less COGS) on Schedule 1 (Form 1040).
• Expenses: Hobby expenses are not deductible from 2018 through 2025 due to tax law changes.

Why This Matters

Failing to correctly classify an activity can lead to missed deductions or penalties. If your activity consistently generates losses and lacks evidence of a profit motive, the IRS may classify it as a hobby, limiting your tax benefits.

At PaperWerks, we’re here to help you navigate these rules and ensure compliance while maximizing your tax benefits. Contact us today for expert advice on your business or hobby activity!

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