Is Your Favorite Pastime Turning Into a Small Business? The IRS Wants to Know.
If you’re making $400 or more on your hobby, it’s time to start declaring it on your income taxes.
We take on hobbies because we enjoy them. But at some point, we sometimes get enough people wanting the woven towels or the birdhouses or the Christmas ornaments we make that it’s time to start charging for them. Supplies cost money, and your time is certainly worth something.
A lot of people get started that way. Before you know it, they’ve set up a shop on Etsy and started exhibiting at craft shows. At what point does this become a business, they may ask themselves.
If you’re bringing in $400 or more per year on your side gig, you should know that there are two good reasons why you should be reporting your business on your Form 1040:
• You’ll be able to deduct at least some of your expenses, and,
• The IRS mandates it.
8 Questions
When your hobby becomes a small business, you’ll have to complete and file a Schedule C with your 1040.
If your personal enterprise has turned a profit in three of the last five years, it’s quite likely that your creative endeavors have become something that requires a Schedule C along with your 1040. The IRS suggests that you ask yourself eight questions to help determine whether it considers you a business and not a hobby. They go something like this:
1. Does the time and effort you put into the activity show you intend to make a profit?
2. Does the activity make a profit in some years, and if so, how much profit does it make?
3. Can you expect to make a future profit from the appreciation of the assets used in the activity?
4. Do you depend on income from the activity for (at least part of) your livelihood?
5. Are any losses due to circumstances beyond your control or are the losses normal for the startup phase of your type of business?
6. Do you change your methods of operation to improve profitability?
7. Do you carry out the activity in a businesslike manner and keep complete and accurate books and records?
8. Do you and any advisors you might work with have the knowledge needed to carry out the activity as a successful business?
How Will You Report Your Income?
Depending on how much money you make and where/how you sell your products, you may receive a 1099 of some sort. If you accept credit cards, it will most likely be the 1099-K: Payment Card and Third-Party Network Transactions. If you take checks and cash, you’ll have to add it all up yourself. Keep any documentation you have if this is the case. You’ll report this on your Schedule C.
How Will You Know If An Expense Is Deductible?
Some business expenses are obvious. If you’re making birdhouses, for example, everything you buy to assemble them should be considered part of your Cost of Goods Sold. If you’re buying products wholesale and reselling them, that should be deductible, too.
But there’s a lot of gray area. The IRS says that legitimate business expenses are those that are “ordinary and necessary.” An ordinary expense is one that is typical and widely accepted in your industry. A necessary expense, on the other hand, is one that is useful and appropriate for your business operations. An expense doesn't need to be essential to qualify as necessary.
Some small business owners really stretch the interpretation of “ordinary and necessary.” There’s a famous case where a company that had a warehouse tried to deduct the cost of cat food. The contents of the warehouse were attracting rodents and snakes, and they wanted to feed stray cats who would keep the population of unwanted visitors down. The IRS accepted it as a legitimate business expense.
Our point here is not that you should try to find some outlandish business expenses to deduct. But we want you to really think about what it costs you to do business. If you’re ever audited, you’ll have to make a case to the IRS about why you claimed a particular purchase as necessary for your business. Keep meticulous records of your purchases.
On to a New Year
Keep these things in mind as we move into a new year – and tax preparation season. You may want to consider reclassifying your hobby as a business and filing a Schedule C with your 1040. We’re not IRS auditors, of course, so we can’t tell you whether a certain purchase will be considered a deductible business expense. But we can help you deal with the tax-related issues you’ll face should you decide it’s time for you to start claiming income and expenses for your pastime-turned-business.
We take on hobbies because we enjoy them. But at some point, we sometimes get enough people wanting the woven towels or the birdhouses or the Christmas ornaments we make that it’s time to start charging for them. Supplies cost money, and your time is certainly worth something.
A lot of people get started that way. Before you know it, they’ve set up a shop on Etsy and started exhibiting at craft shows. At what point does this become a business, they may ask themselves.
If you’re bringing in $400 or more per year on your side gig, you should know that there are two good reasons why you should be reporting your business on your Form 1040:
• You’ll be able to deduct at least some of your expenses, and,
• The IRS mandates it.
8 Questions
When your hobby becomes a small business, you’ll have to complete and file a Schedule C with your 1040.
If your personal enterprise has turned a profit in three of the last five years, it’s quite likely that your creative endeavors have become something that requires a Schedule C along with your 1040. The IRS suggests that you ask yourself eight questions to help determine whether it considers you a business and not a hobby. They go something like this:
1. Does the time and effort you put into the activity show you intend to make a profit?
2. Does the activity make a profit in some years, and if so, how much profit does it make?
3. Can you expect to make a future profit from the appreciation of the assets used in the activity?
4. Do you depend on income from the activity for (at least part of) your livelihood?
5. Are any losses due to circumstances beyond your control or are the losses normal for the startup phase of your type of business?
6. Do you change your methods of operation to improve profitability?
7. Do you carry out the activity in a businesslike manner and keep complete and accurate books and records?
8. Do you and any advisors you might work with have the knowledge needed to carry out the activity as a successful business?
How Will You Report Your Income?
Depending on how much money you make and where/how you sell your products, you may receive a 1099 of some sort. If you accept credit cards, it will most likely be the 1099-K: Payment Card and Third-Party Network Transactions. If you take checks and cash, you’ll have to add it all up yourself. Keep any documentation you have if this is the case. You’ll report this on your Schedule C.
How Will You Know If An Expense Is Deductible?
Some business expenses are obvious. If you’re making birdhouses, for example, everything you buy to assemble them should be considered part of your Cost of Goods Sold. If you’re buying products wholesale and reselling them, that should be deductible, too.
But there’s a lot of gray area. The IRS says that legitimate business expenses are those that are “ordinary and necessary.” An ordinary expense is one that is typical and widely accepted in your industry. A necessary expense, on the other hand, is one that is useful and appropriate for your business operations. An expense doesn't need to be essential to qualify as necessary.
Some small business owners really stretch the interpretation of “ordinary and necessary.” There’s a famous case where a company that had a warehouse tried to deduct the cost of cat food. The contents of the warehouse were attracting rodents and snakes, and they wanted to feed stray cats who would keep the population of unwanted visitors down. The IRS accepted it as a legitimate business expense.
Our point here is not that you should try to find some outlandish business expenses to deduct. But we want you to really think about what it costs you to do business. If you’re ever audited, you’ll have to make a case to the IRS about why you claimed a particular purchase as necessary for your business. Keep meticulous records of your purchases.
On to a New Year
Keep these things in mind as we move into a new year – and tax preparation season. You may want to consider reclassifying your hobby as a business and filing a Schedule C with your 1040. We’re not IRS auditors, of course, so we can’t tell you whether a certain purchase will be considered a deductible business expense. But we can help you deal with the tax-related issues you’ll face should you decide it’s time for you to start claiming income and expenses for your pastime-turned-business.