The IRS treats an activity as a business if you run it to make a profit, and as a hobby if you do it mainly for enjoyment. It decides from how you behave: whether you keep proper books, put in real time, change what isn’t working and depend on the income. Making a profit in three of the last five years creates a presumption that it’s a business. The label matters because a hobby’s income is taxed while its expenses aren’t deductible at all.
Why the label matters
| Business | Hobby | |
|---|---|---|
| Where it goes | Schedule C | Schedule 1, other income |
| Expenses deductible? | Yes: $4,000 | No |
| Income taxed | $2,000 profit | $6,000 |
| Self-employment tax | Yes, on the profit | No |
| A loss can offset other income? | Yes | No |
For anything with real costs, business treatment is usually better, even after self-employment tax. Hobby treatment can only come out ahead for an activity with almost no expenses.
What the IRS looks at
No single factor decides it. The IRS weighs whether:
- you run it in a businesslike way, with complete and accurate records;
- the time and effort you put in suggest you mean to make a profit;
- you depend on the income, or have other income to fund it;
- losses come from things outside your control, or are normal for a start-up;
- you have changed how you operate to make it profitable;
- you, or your advisers, know how to run this kind of business, and you have succeeded with similar ones;
- it makes a profit in some years, and how much;
- you expect a profit from assets used in it rising in value;
- personal enjoyment is the main motive.
The 3-of-5-years test
If the activity made a profit in at least three of the last five tax years (two of seven for breeding, training or racing horses), it is presumed to be a business. Missing the test doesn’t make it a hobby; it just means the factors above decide. A new venture can file Form 5213 to postpone the decision until its fifth year, though that also extends the time the IRS has to examine those years.
Selling on Etsy, eBay and apps
Payment platforms send a 1099-K once your sales pass the reporting threshold, and the form says nothing about hobby or business; you decide that on your return. Selling your own used things for less than you paid isn’t income at all. Making and selling things, or reselling for a markup, is either a hobby or a business, and the 1099-K guide covers how to report it.
Running it like a business
If you mean it as a business, make that visible: a separate bank account, income and expenses recorded as they happen, a simple plan, and changes when the numbers say so. Those are the same habits that keep the tax right. Your first year self-employed covers the set-up, and BrassWell keeps the records and the tax set-aside together from the first sale.
Questions, answered
How does the IRS decide if something is a hobby or a business?
By whether you run it to make a profit, judged from factors such as businesslike records, time and effort, dependence on the income, changes made to improve profit, expertise, and the history of profits and losses. No single factor decides it.
What is the 3-of-5-years rule?
If an activity made a profit in at least three of the last five tax years, the IRS presumes it is a business. Not meeting it does not automatically make it a hobby.
Can I deduct hobby expenses?
No. Hobby income must be reported, but hobby expenses are not deductible under current law.
Do I pay self-employment tax on hobby income?
No. Self-employment tax applies to business profit. Hobby income is subject to income tax only.
Sources
- Here’s how to tell the difference between a hobby and a business for tax purposes — IRS. The factors, and where hobby income is reported.
- About Form 5213, Election to Postpone Determination — IRS. Postponing the hobby-or-business decision for a new activity.
- 26 U.S. Code § 183, Activities not engaged in for profit — Legal Information Institute. The 3-of-5-years presumption.
