If you’re able to make a profit from your hobby, even if it’s a very small profit, you can most likely deduct the costs on your taxes.
Could Your Hobby Be a Business?
Let’s say your hobby is knitting hats and scarves. The cost of knitting might include yarn, needles, and knitting patterns. If you’re able to start selling some of your hats and scarves online, you might be able to start deducting the cost of your hobby from your taxes. You could potentially even make a small profit while getting the IRS to help cover the cost of your hobby. You can claim your expenses on Schedule C. That’s the tax form that calculates net taxable income for sole proprietors, independent contractors, and some business owners. And you can show a loss on Schedule C that can offset other income. And you’re not limited to deducting just the cost of supplies. You can deduct a portion of your mortgage and utilities if you use part of your home solely to deal with the administrative duties of running your business. You can deduct travel expenses and mileage related to doing business. You can deduct all “necessary” and “ordinary” expenses incurred when that hobby becomes a money-making enterprise.
How To Turn a Hobby into a Business
You can’t simply tell the IRS, “OK, this is a business now,” and be done with it. Your activities must reflect your goal. You must demonstrate to the IRS that you’re knitting because you expect to earn a profit from doing so. This means one of two things:
You’ve made a profit from your pursuit in at least three of the last five years.You can pass the IRS “factors and circumstance” test.
You might not have turned a profit yet, particularly in the first year. But the IRS will need to agree that you’re running a business when it looks at the big picture. The IRS considers several factors when it’s judging the big picture. It will want to know whether you keep detailed and accurate financial records. Depending on the business, you might want to establish a separate bank account for your endeavor. Don’t allow any overlap between business and personal expenses. For example, don’t make your car payment from the business account. The IRS will review whether you have the training, education, knowledge, or skill to make your endeavor profitable. You should hire or at least consult with someone who does have the necessary know-how if you don’t. The IRS also wants to know that you depend on the income from your enterprise for at least a portion of your livelihood. You’ll either need to make a profit from your business, or you’ll have to show that you devote a fairly substantial amount of time to it. This requirement doesn’t mean that you have to quit your day job, but be prepared to burn a fair amount of midnight oil and sacrifice your weekends if you don’t. The IRS also looks at whether you spend money on things like advertising and promotion, or to attend conferences, trade shows, and other networking activities. Finally, it will want to see that you’ve made adjustments and changes to your operation to turn those losses into profits. The IRS doesn’t expect you to earn a profit right out of the box. It’s understandable if you suffer a loss for a year or two. Many startups and new businesses do. But it can be a good indicator that you’re operating to earn a profit if you at least come close to covering your expenses.
Pay the Appropriate Taxes
You’ll need to file Schedule C with your 1040 tax return because you’re technically running a business now, even if it’s not the main part of your income. Keep in mind that you’ll have to pay self-employment taxes on Social Security and Medicare. You pay these taxes as an employee, too, but as an employee, you only pay half in this case. Your employer would contribute the other half. You’re considered both employer and employee when you’re running a business, so you have to pay both halves. However, the IRS lets you take a deduction for half these taxes when you file your return. The IRS doesn’t want to wait until you file your tax return to begin collecting taxes from you, either. You might need to pay estimated income taxes and your self-employment taxes quarterly as the year goes on, if you make enough money off of your business. You’ll end up paying interest and possibly penalties otherwise. However, if you have a full-time job and you only make a few hundred dollars a year in profit from your hobby-turned-business, you most likely won’t need to make estimated payments throughout the year. Just know that your tax bill may be slightly higher than originally anticipated.
What If the IRS Asks for Proof?
The need to keep meticulous records can’t be overstated. Just make sure you meet the IRS requirements for a business, and you have proof of the income you received from the services you rendered, as well as proof of the cost of any expenses you deduct.
