Succeeding in Your Business: Determining if your side hustle is a business or hobby

Cliff Ennico 

Doing something fun and making a little money at it? Maybe you sell stuff on eBay, Amazon or Etsy just to clean out your basement and you are (pleasantly) surprised that people in Brazil actually want this stuff and are willing to pay good money for it. Maybe you have a backyard full of chickens and have started selling eggs to folks who can’t find them in their supermarkets. Maybe you love playing golf and are thinking about setting up a golf camp in your backyard to teach the game to local kids. Maybe you’re a retired executive and want to do a little consulting to keep your brain cells from turning into porridge.

Maybe this is the year to turn a cherished hobby into something more closely resembling a “real” business, to take advantage of the tax-deductible expenses that self-employed people enjoy. But whenever I make this suggestion, a number of readers send emails saying, in effect, “But wait a minute, Cliff, I thought the IRS won’t allow you to take deductions for a hobby!” So, some clarification is in order.

If you are making money at whatever you do, the IRS really doesn’t care if it’s a hobby or a business. They want your tax money. Gross income, as the IRS defines it, includes income “from whatever source derived.” Let’s say you collect rare coins or inherited a coin collection from your parents. If you sold two coins on eBay last year just to get them out of your collection — you don’t intend to become a coin dealer — and you made a $100 profit doing so, you should report the $100 as income on your tax return this year. Technically, you should pay state and local sales taxes as well if the buyer lives in your state, but that’s a column for another day.

The “business vs. hobby” distinction comes into play when you lose money. So, in my example above, if you lost $100 when you sold the two coins on eBay (you sold them for less than what you and your parents paid for them), the IRS won’t let you deduct the $100 against your income from other sources (such as your day job). You can only deduct hobby losses against gains from the same or another hobby. So if this year you sell five coins on eBay, making a $200 profit on two of the coins and a $200 loss on the other three, you can net the loss against the profit and report zero income from the hobby.

A professional coin dealer doesn’t have to worry about this because he or she is clearly engaged in a business. How do you tell the difference, especially when the business is buying and selling stuff that many people do as a hobby — such as selling coins or antiques on eBay; breeding cats, dogs or other animals; making arts and crafts for sale at craft shows; publishing a newsletter; participating in various kinds of home party selling where your main objective is to get discounts on the products; and other activities where your primary objective is personal satisfaction rather than economic gain?

Under a long-standing IRS rule, you are considered a business if you made a profit in three of the last five years, including the current year. What if you are just starting out, though, and are likely to lose money this year?

Don’t lose hope. You may still be considered a business for tax purposes if you can prove to the IRS that you are taking your activities seriously and are treating them as a “business” with the primary goal of making a profit — eventually.

So, what sorts of things do you need to do? At a minimum, you should have a name for your business, some stationery, invoices, a separate bank account, separate books and records, a place in your home that is used only for this business activity and some records to show that you are spending some time working on this activity on a regular basis. For example, if you are a coin collector turned coin dealer, you should keep thorough accounts and records, advertise in hobby publications, attend coin shows regularly in your area, register to pay state and local sales taxes and consider forming a corporation or LLC to run the business.

You should also consider preparing a formal business plan showing your projected income and expenses over a five- or 10-year period — with some profit at the end of the period. It would also help you to be able to show that you are actively studying and learning how to be financially successful in your business. Attending seminars, subscribing to trade magazines or newsletters, buying (and reading) books about the business and consultation with various professionals will also help.

Oh, and try not to look as if you’re having too much fun. If the IRS audits your business, and the walls of your “home office” are covered with rock concert posters, you’re toast. Unless, of course, you’re dealing in vintage rock posters.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series “Money Hunt.”

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