What's the Difference Between a Hobby and a Business? The Tax and Legal Lowdown.
I frequently hear people say things like “I just do this as a hobby,” or “I was told that if I make less than x dollars this is just a hobby.”
“Hobby” has a different meaning in a tax context, a legal context, and in a non-tax/legal context. We all understand the colloquial and dictionary definition of a hobby, so we will skip that bit. You’re here for the fun part anyhow right? Taxes and law!
Let’s start with the “why.” Why does it matter if we call your endeavor a hobby or a business? Answer. They are taxed differently. Also, hobbies may require less business structure.
How is a hobby taxed differently than a business?
Business income is subject to both income tax and FICA taxes. FICA is the tax for Medicare and social security. Collectively, I call these self-employment taxes. Federal income taxes range from 10% to 37% based on all income. Self-employment tax is a 15.3% tax on self-employment income.
Let’s look at an example. (If this part gives you a headache, you can just skip over it).
Assume the tax brackets for income tax are:
10% up to $25,000;
20% up to $50,000; and
30% up to $100,000.
Assume you make $50,001 in net business income. Net = income – expenses.
Here’s how tax brackets actually work. That $1 over the 50K is taxed at 30%. The dollars from $25,001 to $50,000 are taxed at 20%, and the first $25,000 is taxed at 10%. This is the essence of graduated tax brackets and the progressive tax system. The math works out to $7,500 in tax, which equates to 15% of total income. Thus, we would say the effective tax rate is 15% despite technically being in the 30% “tax bracket.”
On top of that 15% in income tax, you pay 15.3% self-employment tax on the net income. Thus the total tax equates to 30.3% of income. Please note that this math is just demonstrative and does not include added complexities that work to reduce taxes (e.g. standard deductions, credits, etc.). For more info on those things, check out my tax basics blog.
need some more tax guidance?
Alrighty. We now know how the different tax rates work. The question we must now answer is:
What is self-employment income?
For tax purposes, this is the key question to our topic because income from a hobby is not subject to self-employment tax. Yay! But don’t get too pumped. Hobby income is still subject to typical income tax (those brackets I noted above). Many creatives neglect this bit and think they need not report income from a hobby on the tax return.
So we’re back to square one. Is your endeavor a hobby or a business?
The answer is mostly a question of intent. Are you intending to make a profit? Perhaps more specifically, are you working towards making a profit. It’s common not to profit in our first year, but are you doing the activity to make money?
For example, I knit from time to time. I really am no good at it. It takes 50+ hours for me to produce a scarf. No one would ever adequately compensate me for 500 hours worth of time to get a poorly knitted scarf. That’d be an awful business model. However, if I wanted to sell a scarf once I finished, I could. I would call it a hobby and report the income on my tax return.
But here’s the kicker. I’m will have no net income. Typically, when you have a hobby, expenses will exceed revenue. There’s no profit. Therefore, you wouldn’t need to worry about self-employment tax as it is calculated on net income.
This is the conundrum. People are always super confused when I tell that they may actually want to treat their side hustle, hobby, etc. as a business for tax purposes because they may be allowed more deductions.
The IRS has what they call “hobby loss” rules. See, when your business has a net loss, you can use that loss to offset other income. This is where my tax brain goes whenever someone asks about hobby versus business. Here’s why this rule is important.
Assume that I learn some Photoshop tricks and start to dabble in Illustrator. A friend offers me $200 to do some design work. I think “awesome, I’m in business now.” I decide to buy an iMac Pro for $5,000. That’s all I do that year. I have a $4,800 loss that I can use to offset my law firm income. I do the same thing the next several years racking up thousands in expenses while only making $500. Sounds too good to be true, right? This is where the hobby loss rules come into play. They prevent people from gaming the system.
Here’s the actual rule. If you have made a profit in three of the last five year, the IRS will consider you to have a business. Stated in the reverse, if you have a net loss for three out of five years, the IRS will consider you to have a hobby. In that case, you only deduct expenses up to the amount of your income. It prevents a “hobby loss.”
If you are not profitable for the specified time, then the IRS can determine you have a business based on factors showing profit motive. They look to things like expertise, time and effort, and if the activity has personal elements of recreation.
We all tend to overthink these things, but look at it this way. The IRS wants to prevent someone with one stream of income (like a full time job) from reducing their taxes by expensing hobbies. If you’re in business full time, you likely can’t afford, as a practical matter, to have a loss for more than one year. I’m using the word “afford” here in the literal sense. We all gotta pay the rent. We keep the expenses down until we’re making money. Therefore, if you’re actually trying to run a legit business, these rules likely are not a problem.
In summary, it’s pretty unlikely that a true hobby would result in profit. Just because your side hustle is fun doesn’t make it a hobby. If you’re contemplating something like, “should I buy this material to keep my costs down to maybe actually make some cash,” then you’re thinking like a business person and may as well treat your income as such.
What about all the biz legal stuff?
Let’s look at three categories of creatives to provide some context.
Anne - the hobbyist
Anne loves weddings and events. She’s a full time mom and does not have a primary stream of income. All of Anne’s friends know that she loves Pinterest and is always looking at venues, invitations, and other fun stuff. She’s hyper organized and good at planning. A friend of Anne’s asks her to help pull together her wedding. Anne does this. As a thank you Anne’s friend gives Anne a $500 gift card as a thank you. We’re going to call Anne’s wedding planning a hobby. She doesn’t intend to market herself. If another friend asks for help she will happily do it but not expect much, if any, compensation.
Under the tax law, Anne’s $500 gift is income for services and would need to go on the return as hobby income. If however Anne had expenses, she may want to deduct those to reduce her $500 in taxable income. We could treat the service as a business and file a Schedule C to report this as biz income and take those deductions. This is not a problem whatsoever if she’s taking reasonable deductions and not trying to show losses.
dave - the “freelancer”
Now, let’s look at Dave. Dave is a nurse. He has been getting into photography. He does some family shoots for close friends. Then, he decides to second shoot a few weddings. Dave makes $4,000 doing photography. He’s also a bit of an equipment enthusiast, so he spent more than that on camera equipment. He does not have a business name and has not started marketing himself. Most of us would call Dave a freelancer. Some might even say he is a hobbyist like Anne.
For tax purposes, we would treat Dave as business owner despite being a freelancer. He’s performing services for compensation. Even if he’s not putting forth much of a marketing effort, he’s still acting like a freelance photographer. Although, he has a net loss, he will likely breakeven and start to get some income in the next couple of years. It’s perfectly fine for Dave to report a loss from his business.
rachel - the new biz owner
Rachel’s story looks a lot like Dave’s, but she just branded herself and launched a website, Her business is Rachel’s Fine Photos. She still has her full-time gig, but hopes to turn her side hustle into her main hustle as soon as she’s able. Rachel definitely has a business for tax purposes. For legal purposes, she’s a business owner as well and should start considering herself one by looking into business licenses, DBAs, LLCs, Trademarks, Copyrights and all that jazz.
The real gray area is those of you who’s biz looks like Dave. If you don’t have a business name, you need not have a DBA. You might need a local business license depending on the rules in your city. An LLC is not a bad idea, but you’re probably not thinking about that just yet. I would recommend all the Dave’s out there treat themselves as business owners at least for the purposes of banking and bookkeeping. Dave also needs to start thinking about quarterly taxes. Once he anticipates making a profit, he should start making estimated quarterly payments.
When someone approaches me and says “I was told that I just have a hobby. Is that right,” I kind of freeze. You can now see why. My mind is going 7 directions thinking “well are we talking about taxes, legalities, whether you need to brand yourself, or did you read about the hobby loss rules and are worried about that.”
The truth is that if you only operated a hobby, you likely would not have found your way to this article. Therefore, the question you need to answer is “If I do have a business, what tax and legal steps do I need to take for my business?”