Most people have hobbies they like to pursue in their spare time, and some people spend quite a bit of money on them. Just ask stores such as A.C. Moore
To help cover their costs, some hobbyists find ways to make money doing what they love. They're often successful in finding niches that appeal to others who are serious about the same hobby and can make money from people willing to pay for things such as training or product innovations.
But anytime somebody's making money, you can count on the IRS getting involved. The tax laws treat hobbies differently from business activities, so if you're making money on your hobby, it's important that you understand whether the tax laws consider you a hobbyist or a full-fledged small-business owner. There are advantages and disadvantages to falling within either category, and you need to know how best to take advantage of whichever one applies to you.
Tax treatment for hobbies
The way the tax laws treat hobbies is quite different from the way businesses are taxed. With hobbies, the general rule is that you can't take any money you spend on your hobby as a deduction. However, if you earn income from your hobby, then you're allowed to deduct hobby expenses up to your hobby income. For instance, if you made $500 from your hobby but spent $1,000 to generate that income, then you'd be allowed to deduct just $500. Furthermore, the deduction is technically a miscellaneous itemized deduction, so you must itemize to claim it. But this also means that if your total miscellaneous deductions don't exceed 2% of your adjusted gross income, you may not be eligible at all for a deduction.
In contrast, businesses generally get to deduct the full amount of expenses they incur in the ordinary course of doing business. As a result, using the above example, a business might be able to claim a $500 loss, which the taxpayer could use to offset other taxable income. Because of the value of being able to deduct expenses, many hobbyists seek ways to have their activities treated as a business for tax purposes.
The IRS test
The IRS has a relatively simple test for determining whether someone is engaged in a hobby or a business. The main issue is whether you are trying to make a profit through your work, which is a goal of businesses but typically not of hobbyists.
However, just because you don't make a profit in a given year, that doesn't mean you didn't intend to make money. The IRS looks at several factors to determine whether you have a profit motive. These include the way in which you operate, how much time and effort you spend on the activity, whether you're financially dependent on the activity for your livelihood, what your level of expertise is, and what actions you take to try to make the activity more profitable. The IRS will also look back to see whether you've made profits in a good number of past years. If you have, you'll more likely be treated as a business for tax purposes. But if you consistently spend more in expenses than you earn in income, the IRS is likely to decide that you don't really have an interest in making money from your labor and will classify what you're doing as a hobby.
Sometimes, you just can't win
Unfortunately, the IRS test often results in your paying the most tax possible. If you don't make enough money to turn a profit, then being treated as a hobby will mean that you won't get the full tax benefit from the expenses you pay. Yet if you do earn a profit, you'll be treated as a business. You'll be able to deduct your business expenses, but you'll also be subject to additional taxes as the owner of a self-employed business -- and self-employment tax rates can run as high as 15.3%. Not being prepared to pay can mean you don't pay enough estimated taxes throughout the year, a problem that can lead to underpayment penalties.
Ideally, hobbyists would prefer that the treatment be the other way around. Hobby income isn't subject to self-employment tax, so when their activities do make money, hobbyists would prefer to classify their income as hobby-related. The way the tax laws are written, however, the IRS usually gets the better deal, no matter what your situation.
During the months leading up to the mid-April tax deadline, enterprising taxpayers often look for new ways to take deductions or otherwise reduce their tax liability. As a potential source of deductible expenses, hobbies are a promising target that many taxpayers consider using. In most cases, however, the money you spend on your hobbies is off-limits as a source of tax benefits. Only if you're serious about what you're doing and about making money from it are you likely to get the business treatment that will let you use those valuable deductions.
With tax time here again, you'll find lots of helpful resources in The Motley Fool's Tax Center, including articles on common tax issues, ways to avoid typical mistakes, and things to watch out for on your own return.
Fool contributor Dan Caplinger has made much more than a hobby out of his writing. He doesn't own shares of any of the companies mentioned in this article. The Fool's disclosure policy is our commitment to you.