Are you earning money from a side hustle or creative pursuit? It’s important to understand how the IRS classifies that activity. Is it a legitimate business or just a hobby? In this video, Matt Richardson, a Senior Tax Accountant at CK, explains how the IRS makes that distinction, what factors they consider and why it matters. Whether you’re selling art, playing music or driving for a rideshare app, Matt breaks down what you need to know.

Transcript

My name is Matt Richardson. I’m a senior tax accountant at Cray Kaiser. So if you do anything that earns money on your own time, the IRS will either consider it a hobby or a trade or business. And for the IRS, a trade or business is something that you’re doing to earn a profit or to make a living. Whereas a hobby is something that you do mostly for fun. And to decide whether your activity is a hobby or a business, the IRS will look for a profit- seeking motive. So the IRS has a few different ways to look for a profit-seeking motive. But the big theme is whether you operate your activity like a for-profit business would. A major part of that is whether it is something a lot of people would do recreationally. Whether or not you made or lost money. And for example, a lot of people might play music just for fun. So the IRS might question whether your weekend rock band is a true business. But not many people do accounting just for fun. So that’s a kind of business that’s less likely to get questioned by the IRS.

Other sources of income are also part of what the IRS looks at. If it’s your only means of support, they’ll usually accept that it’s a business that you’re trying to earn a living from. But if you also receive a six-figure salary from a day job, then they’re more likely to question the business aspect of your activity.

And a few other things they look at can include your expertise in the activity, how much time and effort you put in, the amount of profit you’ve earned in past years, whether you keep detailed financial records, how actively you seek out customers, and whether you have a written business plan, including a budget and growth strategies.

So for taxes, the main difference is if you’re a business, you’re allowed to deduct your expenses. You’re only taxed on what’s left over after you take what you earned and subtract what you spent in the process of doing that. If it’s a hobby, you have to pay taxes on all the money that you earn, but you can’t deduct those expenses. So, obviously, that makes a pretty big difference in your tax liability, so the IRS can be pretty assertive in questioning things that it thinks might really be a hobby.

So, unfortunately, there’s no clear-cut dividing line between a business and a hobby. As the IRS likes to say it depends on all the facts and circumstances. So they’ll look at the activity in the context of everything that you do to decide whether it looks like a hobby or it looks like a business. They do have one general rule that will protect you in most cases, which is if you if you earn a profit in three out of the last five years then they’ll usually accept your classification as a business.

So overall the IRS is more likely to ask questions if the activity would let you claim expenses on property that you’d likely own anyhow, especially if it’s recreational. Some specific examples are horse racing has a lot of specific rules, things like auto racing, creative things like arts, crafts, and design. Writing, especially self-published books or blogs that might earn income are things they might look at. For social media, if you’re posting or live streaming and earning some money on the side that’s something that they might look at as being a hobby and not a real business. Music is another thing they’ll look at. A lot of people wish they could deduct their $60,000 Fender Stratocaster guitar, but if you’re just playing a couple of gigs a month with some friends, they’re probably not going to consider that to be a true business. Aviation is another area they look at. People might own an airplane and charge their friends a few dollars to ride around in it, hoping that they can deduct the expense as a business but chances are the IRS will will question you on that. And even rideshare driving like Uber or Lyft if you’re doing it just a few hours a week on the side that’s even something that the IRS might question you on is whether it’s a true business or not.

So a simple example of something that could go either way would be someone who paints watercolors in their spare time and decides to sell them. So you’ll probably be considered a business if you’re actively promoting your paintings and going to arts and crafts shows. If you’re keeping detailed financial records of your costs and supplies and booth rental fees. And if you’re charging a price for those paintings comparable to what most people would charge for those at similar arts and crafts shows. You’ll probably get classified as a hobby, if you’re only customers are friends, family, neighbors, people that you already know, and you don’t really advertise more widely. If you keep no records of how much you’ve spent on supplies, and make no effort to track expenses separately from personal expenses, and if you charge less for paintings than the canvas and the materials cost, chances are that will get you classified as a hobby.

So nothing can totally guarantee that the IRS won’t challenge you, they can essentially challenge you on anything. But there are four things that will help you be pretty secure. Keep detailed financial records, keep detailed records of the time you spend in the activity, maintain written business records, including a budget and a business plan, and of course talk to your tax advisor. That’s what we’re here for.