Blog Post

Hobby vs. Business: Why It Matters 

Staff Writer • Nov 26, 2018

In our last post, we discussed the sharing economy and the wisdom of generating multiple income streams. In this one, we look at the difference between a hobby and a business. While we might view the growth of a hobby into a business as a natural, gradual process, the IRS considers the two to be distinct and has different rules regarding the expenses associated with them.

According to the IRS, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit . The IRS provides a list of questions taxpayers should consider. The more “YES” answers one has, the more likely the activity is a business.


  • Do the time and effort put into the activity indicate an intention to make a profit?
  • Does the taxpayer depend on income from the activity?
  • If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
  • Has the taxpayer changed methods of operation to improve profitability?
  • Does the taxpayer have the knowledge needed to carry on the activity as a successful business?
  • Has the taxpayer made a profit in similar activities in the past?
  • Does the activity make a profit in some years?
  • Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?

The IRS’s general rule of thumb is that a business will make a profit three years out of the last five (including the current filing). The big exception is real estate. Much of the profit in real estate comes through appreciation of assets when the properties are sold, not in steady yearly returns.

The difference between the two, tax-wise, is whether expenses associated with the income from the activity are deductible expenses or not.

A business activity reports gross income and then deducts the ordinary and necessary expenses used to generate that income. For example, a restaurant owner reports gross sales and then deducts rent, raw ingredients, tools, payroll, utilities, cost of licenses, etc. Those are ordinary and necessary expenses. A trip to Rome to “research” Italian cooking and ingredients would not be ordinary, might not be necessary, and the IRS could disallow it as a deductible expense. If expenses are greater than income one year, the business has a loss which can offset other taxpayer income.

A hobby is considered to generate only income, because the IRS thinks that the hobbyist would incur the expenses anyway, for pleasure, whether or not any income was generated. Big Yard Cards of Jacksonville, Florida, started as a hobby ( https://www.bigyardcard.com). The owner enjoyed pranking people and toilet papering yards. He did it so well, people started paying him to do it for them. The IRS was correct: He did this activity for fun at first. Any income was just gravy.

Under the previous tax code, hobbyists could claim hobby expenses up to the amount of income reported from the hobby. This limit kept hobbyists from taking the losses that businesses can. The expenses were claimed as a miscellaneous Schedule A deduction. Those miscellaneous deductions are now gone. We can’t claim any of them until at least 2026.

Since hobby expenses are disallowed, what options remain if we want the deductions?

First, if we want to deduct expenses, we have to change our thinking and our practices. We must think of the activity as a small, new business and start good business practices. Just as children do best when raised in good environments, businesses do best when started with good practices. Here are some recommendations gathered from the IRS, from small business websites, and from accounting firms:


  • Set up a separate checking account for the business . Hint: it doesn’t have to be in the business’s name, but it should be used for just that business activity. Most credit unions, for example, charge little (if anything) to open a second account associated with the first. A separate account is one sign to the IRS that the activity has moved out of the hobby stage.
  • Keep business and personal expenses separate . Don’t put business expenses on a personal credit card or debit the business account for personal expenses. With online banking, it is easier than ever to move money from one account to another. If you need to pay your water bill out of your profits, first transfer the money from the business account to your personal one, then pay the bill out of personal funds. If you absolutely must pay business expenses on a personal credit card (NOT recommended), then use the personal credit card to buy a loadable VISA, which can then be put into the business account. This attention to financial detail is a strong indicator you are becoming serious about profits because it is easier to see if you are profitable if business and personal funds aren’t mingled.

  • Maintain a good business record-keeping system . This follows up on the money example above. Keep information on customers, vendors, what works, what doesn’t, contacts made, project notes, ideas for improvements, etc. Whatever word processing and spreadsheet software you have is good enough at this stage. A notebook or ledger will also serve the purpose, as long as you use it.
  • Register the business with the state as an LLC or partnership . You might want to wait a bit on this one. On the one hand, registering as an LLC provides some liability protection for your personal assets. On the other, registering with Tennessee as an LLC requires filing a number of annual forms which lead to tax bills. You might chose to wait until the business is out of the red.
  • Follow state and local rules about business licenses and collecting sales tax . Hobbyists don’t bother about business licenses or collecting sales tax because they are only occasional sellers whose yearly gross equals a decent yard sale or two. Businesses follow the rules because they expect to grow and hopefully thrive, not fly under the radar. If you have questions about those rules, come see us.
  • Have regular business hours and/or maintain a business website . When your business is just starting out, a side business, or seasonal, then regular office hours are unlikely. If, for example, you have a side business putting up and taking down special occasion décor like Big Yard Cards does, a website is sufficient for clients to find you so that they can order a flock of flamingos for someone’s 50th birthday.
  • Upgrade your business skills . The Tennessee Small Business Development Center ( https://www.tsbdc.org/ ) has a number of free resources, both downloadable PDFs and online seminars. Getting training helps satisfy the IRS’s knowledge requirement listed above.

If the suggestions above seem overwhelming, then the hobby category may currently be right for you. However, if you want to grow your hobby into a business in which you can deduct your expenses, the steps above will both show the IRS that you are serious about making a profit and put you in a solid position to do so.

Qualified Opportunity Zones Q&A

By Staff Writer • 18 Dec, 2019
You may have heard buzz about qualified opportunity zones (QOZs), an investment opportunity that allows you to defer taxes on reinvested capital gains and to exclude some of those gains permanently from taxation. What are these QOZs, and how do they work? We address the most common questions in this post.

Tennessee Business Taxes & Fees: A Primer

By Staff Writer • 14 Dec, 2018
In our last post, we discussed ways to grow an income stream into a business for tax purposes so that you can deduct your expenses. One of the strategies is to register with the state as an LLC or partnership. Another is to follow the state’s rules about licensing and taxation. This post will look more closely at these topics.

Uber, Airbnb, & the Sharing Economy: What You Need to Know

By Staff Writer • 29 Oct, 2018
There are many benefits to the sharing economy, and knowing what your goals, boundaries, and liabilities are before jumping in, can save you a lot of time and wasted resources.

The Qualified Business Income Deduction: Questions and Answers

By Virginia Perry • 24 Sep, 2018
One of the business-favorable provisions of the 2017 Tax Cuts & Jobs Act (TCJA) allows pass-through entities to deduct up to 20% of their qualified business income (QBI) from their taxable income. Since few people want to read that for themselves, we are summarizing it here in a question-answer format.

Why You Should Consider Partnering with a CPA

By Miller & McPhail, CPA • 24 Aug, 2018
Insteadof the wing and a prayer method when it comes to filing your taxes, use a certified public accountant.

New Tax Changes

By Staff Writer • 31 Jan, 2018
2018 TAX CUTS AND JOB ACT (TCJA) INDIVIDUALS TCJA will lower tax rates (top rate reduced from 39.6% to 37%) at many levels but impact to individuals/families will depend on a variety of other changes made by the Act Most provisions begin 1/1/2018 and end 12/31/2025 Increase in Standard Deductions to $24,000 for joint filers, $18,000 for Head of Households, and $12,000 for Single and Married Filing Separately Loss of Personal and Dependency exemptions Change in Itemized Deductions: State and Local Taxes - $10,000 limit on aggregate property, state and local taxes as an itemized deduction Medical Expenses - will revert back to the 7.5% AGI reduction for 2017 and 2018 and then 10% for 2019 and forward Interest you pay – Home Equity Loan Interest no longer deductible Charitable Contributions – Total Cash contributions deductible up to 60% AGI. No deductions for seating rights for college sporting events Casualty and Theft Losses – deductible only if due to federally declared disaster Employee Reimbursed Job Expenses and Miscellaneous Deductions will no longer be deductible including safe deposit boxes, tax preparation fees, investment fees, gambling losses Moving Expenses – no deduction except for certain military personnel Alimony – for post 2018 divorce degrees and separation agreements, alimony will not be deductible by the paying spouse and will not be taxable to the receiving spouse. 529 Plans – may now be used for educational expenses at an elementary or secondary public, private or religious school Kiddie Tax – unearned income of a child now taxed at the capital gains and ordinary tax rates for trusts and estates Child and Family Tax Credit – Credit increased to $2000 for qualifying children under 17 and refundable portion of credit to $1400. New $500 credit for dependents who are not qualifying children. Credits now phased out at $400,000 for joint filers. Health Care “Individual Mandate” – Beginning 2019, there is no longer a penalty for individuals who fail to obtain minimum essential health coverage. There is no change to the large employer mandate to provide insurance BUSINESSES Tax Rates for C Corporations – beginning 2018 tax year – 21% flat tax rate and eliminates the corporate AMT New 20% Deduction for Qualified Business Income from a Pass-through entity such as Partnership, S Corporation or Sole Proprietorship reduces taxable income but not adjusted gross income and will phase out for income from certain services For taxpayers with income above $315,000 joint and $157,500 single, limitation on W-2 wages and value of depreciable fixed assets is phased in deduction phased out for income from certain service related businesses Deduction is not available to: businesses which provide services in the fields of accounting, actuarial science, athletics, brokerage services, investing, consulting, financial services, health, law or the performing arts or whose principal asset is the reputation or skill of one or more of its employees or owner Bonus Depreciation – Property placed in service after 9/27/17, 100% deduction – New or used property 100% begins decreasing inn year 2023 to 80% and down to 0% by 2027 Section 179 Expensing – increased to $1 Million in 2018 and expands the definition of qualified property Health Care Coverage for Employees - There is no change to the large employer mandate to provide insurance Entertainment Expense and Club Dues: No deduction is allowable with an activity generally considered entertainment, amusement or recreation No deduction for membership in clubs organized for business, pleasure, recreation or other social purpose Net Operating Losses – beginning 2018, carryback provision is eliminated and NOLs can be carried forward indefinitely Like Kind Exchanges – will limit tax-free exchanges to exchange of real property that is not held primarily for sale, thus, personal property like autos and intangible property cannot qualify for tax-free like kind exchanges. Withholding on Employee Wages – because of new tax rates for 2018, tax withholding tables will change. IRS indicates it will release these tables in January for employers to begin using in February 2018 ESTATES Tax exemptions for estates doubled to $10 million per person beginning 1/1/2018 and indexing to approximately $11.2 million by 2018 Marilyn L. Miller, CPA 123 W. Washington Ave. Athens, TN 37303 (423)745-6680 Jason G. McPhail, CPA 345 Frazier Avenue, Suite 207 Chattanooga, TN 37405 (423)756-7002
Share by: