Hobby or Business? How to Decide and What It Means for Your Taxes
Whether it’s crafting jewelry, flipping vintage finds, or teaching yoga classes on weekends, many people find themselves asking: Is this a hobby or a business? While the distinction might seem like just a matter of perspective, it has important implications—especially when tax time rolls around.
Let’s explore how to determine whether you’re running a business or simply enjoying a hobby, and why the difference matters more than you might think.
Hobby vs. Business: What’s the Key Difference?
At the heart of it, the IRS makes a clear distinction:
Businesses are operated with the intent to make a profit.
Hobbies are activities done for pleasure, recreation, or personal interest, regardless of whether they earn money.
But it's not always black and white. A side project can start out as a hobby and gradually grow into a business—or vice versa. If you're earning money, even occasionally, you need to consider how to categorize your activity.
Why It Matters for Taxes
One major reason the distinction is important? Taxes.
If you get paid for goods or services through platforms like Venmo, PayPal, or Cash App, you may receive an IRS Form 1099-K. This form reports payments received during the year, and those earnings are considered taxable income, whether you're officially running a business or not.
However, how you report that income—and what deductions you're allowed to take—depends on whether you're a hobbyist or a business owner:
Businesses: You can generally deduct ordinary and necessary expenses to reduce your taxable income.
Hobbies: You must report all hobby income, but you cannot deduct hobby-related expenses to offset it, due to IRS changes under the 2017 Tax Cuts and Jobs Act.
Understanding the IRS Hobby Loss Rules
The IRS has what's known as the “hobby loss rule,” which prohibits taxpayers from using hobby losses to offset other income.
Here's how it works:
If the IRS classifies your activity as a hobby, you cannot claim a loss from that activity on your tax return—even if your expenses are higher than your income.
In contrast, if your activity qualifies as a business, and you report it using Schedule C, you may be able to deduct your losses, which could lower your overall tax liability.
To prevent abuse, the IRS uses a "profit test":
If your activity shows a profit in three out of the last five years, including the current year, the IRS generally presumes it’s a business.
If your activity fails the profit test, you must be prepared to prove you're genuinely trying to make a profit—using things like business plans, marketing efforts, accurate books, and adjustments made to improve success.
Failing to meet this standard means your activity is treated as a hobby, and the IRS will disallow any deductions beyond the income it generated.
Questions to Help You Decide
The IRS provides several guiding questions to help you assess whether your activity qualifies as a business:
Do you intend to make a profit?
Do you depend on the income for your livelihood?
Have you made a profit in similar activities in the past?
Do you make changes to improve profitability?
Are your records detailed and accurate, like a real business?
Are your losses due to startup costs or external factors?
Do you or your advisors have the knowledge to run the activity professionally?
Can you expect profits from the future appreciation of assets used in the activity?
No single factor is decisive—the IRS considers the totality of your circumstances.
The Bottom Line: Keep Good Records Either Way
Whether it’s a hobby or a business, the best practice is to track your income and expenses carefully. Keeping clear, organized records will save you stress when it’s time to file your federal tax return—and ensure you stay on the right side of IRS rules.
And if your passion project starts to bring in real income, it might be time to make it official. Turning a hobby into a business not only opens the door to deductions, but can also be the first step in building something bigger.
Final Tip: When in Doubt, Ask a Pro
If you’re unsure how to classify your activity—or want to avoid missteps with IRS rules on hobby losses—consult a tax professional. They can help you evaluate your situation and ensure you're filing properly while maximizing your tax efficiency.
