Hobby or business? IRS offers tips to decide

If you make a dozen cupcakes for your sister and she gives you a couple dollars to cover your expenses, you could probably qualify the baking activity as a hobby. If you take orders online for cupcakes by the dozen and charge a set amount, your baking “hobby” has now become a business. But how do you know when you have crossed the line from hobby to business? And what are the Internal Revenue Service’s rules regarding hobbies and businesses?

When it comes down to it, hobbies are normally done for sport or recreation and not as a money-making venture. The IRS provides nine criteria to determine if your activity is a hobby or a business:

1.   Is the activity carried on in a businesslike manner?

2.   Is the time and effort put into the activity intended to make it profitable?

3.   Is income from the activity depended on for livelihood?

4.   Are losses due to circumstances beyond control?

5.   Are methods of operation changed in an attempt to improve profitability?

6.   Do operators have the knowledge needed to carry on the activity as a successful business?

7.   Was the operator successful in making a profit in similar activities in the past?

8.   Does the activity makes a profit in some years and how much profit it makes?

9.   Are future profits expected from the appreciation of the assets used in the activity?

Any income earned from a hobby must be reported on taxpayer’s tax return. The rules for how to report the income and expenses depend on whether the activity is a hobby or a business. There are special rules and limits for deductions taxpayers can claim for hobbies.

Within certain limits, taxpayers can usually deduct ordinary and necessary hobby expenses. An ordinary expense is one that is common and accepted for the activity. A necessary expense is one that is appropriate for the activity.

Generally, taxpayers can only deduct hobby expenses up to the amount of hobby income. If hobby expenses are more than its income, taxpayers have a loss from the activity. However, a hobby loss can’t be deducted from regular income.

Taxpayers must itemize deductions on their tax return to deduct hobby expenses. Expenses may fall into three types of deductions, and special rules apply to each type.

Hobby rules can be complex and IRS Free File can make filing a tax return easier. IRS Free File is available until Oct. 16. Taxpayers earning $64,000 or less can use brand-name tax software. Those earning more can use Free File Fillable Forms, an electronic version of IRS paper forms. Free File is available only through the IRS.gov website.