Many businesses start as side projects: crafts sold online, photography on weekends, a few rental cars or horses. Whether the activity is a business or a hobby matters, because hobby expenses are generally not deductible while business expenses are. The IRS explains the distinction on its page about hobby or business.

Why it matters

Hobby income is still taxable and must be reported. Under current law, hobby expenses are generally not deductible, so a hobbyist can owe tax on gross hobby income. A business, by contrast, deducts ordinary and necessary expenses and can generally deduct a loss against other income, subject to other limits.

The factors the IRS considers

No single factor decides; the IRS looks at all facts and circumstances, including whether:

  1. The activity is carried on in a businesslike manner, with complete and accurate books
  2. The time and effort put in show an intention to make a profit
  3. You depend on income from the activity
  4. Losses are due to circumstances beyond your control or are normal in the startup phase
  5. You changed methods of operation to improve profitability
  6. You or your advisers have the knowledge to carry it on as a successful business
  7. You have made a profit in similar activities in the past
  8. The activity makes a profit in some years and how much
  9. You can expect to make a future profit from the appreciation of assets used

There is also a presumption: an activity that produces a profit in at least three of the last five tax years is generally presumed to be engaged in for profit, two of seven for horse breeding, training, showing or racing.

How to show a profit motive

  • Keep separate books and a separate bank account; see separate business and personal finances
  • Write a simple business plan with pricing and a path to profit
  • Track time spent on the activity
  • Change what is not working and document the changes
  • Get the licenses and registrations a real business would have

Losses year after year

Consistent losses are the most common trigger for hobby questions. That does not mean a loss-making startup is a hobby; it means the records need to show genuine effort toward profit.

Our role

We set up proper books for side businesses from the start, which supports the "businesslike manner" factor and makes the tax return straightforward. See our bookkeeping services and our guide to tracking startup costs.

Records that support a profit motive

Keep a written business plan, a separate bank account, an accounting system, marketing records and notes on changes made to improve profitability. These documents speak directly to the factors the IRS considers.

Review the activity annually and document changes made to improve profitability, such as new pricing or reduced costs.

Separate accounts make the business's results easy to show.

Key terms

Definitions for terms used in this guide, from our small business glossary:

  • Assets: Assets are resources a business owns or controls that are expected to provide future economic benefit.
  • Ordinary and Necessary Expenses: Ordinary and necessary is the basic test a business expense must meet to be deductible.