Is your side gig a hobby or a business? Why it matters.

Do you have a side gig? A part time job, a little something to bring in extra cash?

 

If not, you should. If only to explore what might turn into a fulltime business AND to make your mistakes when it doesn’t matter.

 

Slight digression here: knowledge is power. If you’re just starting your business or you’re looking at monetizing what’s been a hobby, you need to make sure the IRS considers it a business.

 

Why? If you have a business – rather than a hobby – you can deduct all your expenses associated with it. If it’s just a hobby, you can only deduct expenses up to the amount of income and even then, you’re limited to 2% of your adjusted gross income.

 

That’s important because a business loss can shield other income from taxes, if you’re filing as a sole proprietorship, partnership, LLC, or S-corp (more on those later). A hobby loss can’t.

 

So you need to know how the IRS will decide the issue and plan your venture accordingly.

 

There are two tests for determining whether you’ve got a business or a hobby. Satisfy EITHER ONE of the, and you’re a business. They are:

 

  • Show a profit three out of five years, or

 

  • Pass the “Factors” test.

 

 

Remember that test: three out of five years, show a profit and it’s assumed to be a business. (Two of seven if the activity consists primarily of breeding, showing, training, or racing horses. but what are the odds?)

 

As long as you show a profit three out of five years, the IRS will assume you’ve got a business.

I’m not going to cover the basics of business accounting and Profit and Loss Statements. You need to have a professional handling that. What YOU need to be watching and make clear to your accounting professional is the three year bit. For TWO YEARS out of the five, you can show a loss. You MUST show a profit for the other three years.

 

To show a profit, have income greater than deductions. Forego an entirely legitimate deduction to satisfy this test, if you have to.  Yes, there’s a degree of risk associated with doing that, as the IRS may think you’re playing games with them, but it’s less risky than failing to show a profit three out of five years.

 

The three out of five years test is by far the easier of the two. Produce decent tax returns and boom, problem solved.

 

Well, almost solved. This test creates a PRESUMPTION that it’s a business, but the IRS can still claim it’s not. However, if you satisfy the three out of five years test, the burden shifts to them to prove that it’s a hobby.

 

But suppose you are still pre-profit? (Ouch.) (Also known as losing money, but let’s be kind.)

 

First, you can ask for that determination to be delayed until you’ve had time to satisfy the presumption.

 

Second, IRS section 183 lays out the nine factors that the IRS will consider in determining whether you’re running a business or pursing a hobby. They are:

 

  1. Manner in which the taxpayer carries on the activity.
  2. The expertise of the taxpayer or his advisors.
  3. The time and effort expended by the taxpayer in carrying on the activity.
  4. Expectation that assets used in activity may appreciate in value.
  5. The success of the taxpayer in carrying on other similar or dissimilar activities.
  6. The taxpayer’s history of income or losses with respect to the activity
  7. The amount of occasional profits, if any, which are earned.
  8. The financial status of the taxpayer.
  9. Elements of personal pleasure or recreation

 

Here’s the link for a detailed discussion of each item. If the link doesn’t work, copy and paste this URL:

 

https://www.irs.gov/businesses/small-businesses-self-employed/irc-183-activities-not-engaged-in-for-profit-atg#appendix01

 

 

You see how this works? START OFF keeping the kind of records and doing those activities that will satisfy the Nine Factor test, just in case you can’t finesse the three years of profit.

 

This is stuff your accountant and lawyer won’t tell you about. This is all on you.

 

Note: This does not apply to a C corporation, but you may be able to elect to have your C corp treated as an S corp.

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