Hobby vs business
A small business is challenging to define because the official parameters vary depending on where you’re located. Depending on the country you live in and the industry your business falls under, the parameters of what constitutes a “small” operation are drastically different. In general, anyone who distributes goods or services may be considered a small business, and there are several ways to operate as such.
The primary difference between a hobby and a business in the United States, according to the IRS, is that a business actively tries to earn a profit while a hobby does not. It’s important to keep in mind that while you may consider small amounts of money from your hobby as fun pocket change, the IRS still views it as income you need to claim on your income taxes.
Many people don’t profit in the first few years of a business, but if you’ve registered as a partnership or LLC, you may still require business licenses and be taxed as a business operation. The IRS provides a list of nine factors to account for when determining if you have a hobby or a business. These include considerations like how you conduct your operations, the motivation behind the activity, whether you and your business partners have prior business knowledge/success and what sort of profits you’re making from the work.
If you consider these guidelines carefully, you can evaluate how the IRS perceives a hobby vs business operation and whether you’re exhibiting qualities of a business working for profit rather than a nonprofit hobbyist.
The pros and cons of hobby business vs small business
If you have a hobby that’s starting to turn a profit, you may be wondering whether it’s time to take the plunge into becoming a small business. Here are the pros and cons to consider in a business vs hobby.
- Less pressure
- No need for a business license
- No changes to your tax filing method
- You don’t need to track your expenses
- Sometimes, you may make a significant investment for no financial return
- You can’t deduct hobby-related expenses on your taxes
- No financial profit
Small business pros:
- Ability to make a significant profit from a passion
- You can deduct business-related expenses on your taxes
- You may be eligible for small business loans or grants
- You become your own boss, make your own schedule and manage your own workload
- Flexible working hours
Small business cons:
- You must obtain the appropriate business license and potentially register your business (sole proprietorship vs LLC)
- You need to pay taxes on your business income and file taxes correctly as a small business
- You need to track your expenses diligently
- You may see more loss than profit in the first years of your business, despite actively trying to earn a profit
What is the hobby income limit?
The IRS doesn’t differentiate your hobby income from the rest of your earnings in a given year. For this reason, if your hobby earnings in a calendar year in combination with your primary source of income exceed the limits set out by the IRS, you must include them when filing Form 1040.
If you’re under 65 and filing as an individual, you must declare your hobby earnings if they total $12,400 or more when combined with your other income. If you’re married and filing jointly, the threshold is $24,800 if both spouses are under 65.
Do I have to pay taxes on hobby income?
Whether or not you pay tax on your hobby income depends on the rest of your earnings within that year. If your gross income for a calendar year, including your hobby income, is less than the threshold set out by the IRS, you don’t have to file and pay taxes on the money you made from your hobby. However, when you add your hobby income to your primary wages, your gross annual income may exceed the IRS threshold, requiring you to pay taxes on the hobby income.
Do I need a business license for my hobby?
Whether or not you need a business license for your hobby centers, again, on the guidelines from the IRS. Since the IRS defines a business as actively attempting to turn a profit, you won’t need a business license for your hobby if you’re not earning money from it. For example, if you’re selling handmade craft items on Etsy for the same cost as the materials you buy to make them, you’re only breaking even or putting money into the hobby and not making a profit.
If you’re selling your crafts online through Etsy for a higher price than what you’ve put into making them and are actively earning a profitable income, the IRS would view this as a business endeavor, requiring you to obtain the proper license and potentially an EIN (employer identification number).
The frequency with which you turn a profit may also matter for legal and tax purposes. If you make a profit on one item one time, this may still leave you with a hobby rather than a business. But if you’re starting to see a steady weekly income from profits on your hobby crafts or services, it may appear that you’re now actively attempting to make money rather than enjoying an activity in your spare time.
When to transition from hobby to primary business
So when does making money from a hobby become a borderline business? Based on the IRS definition, as soon as you start to profit from your hobby, you’re already into the small business territory. If you’re earning enough on your hobby income that you’re paying tax on it to the government, it’s worthwhile to consider transitioning to a small business model so you can turn your passion into a viable income source and claim the expenses for it on your tax forms.
If yours is an extremely small operation, it likely makes sense to start out as a sole proprietorship. In a sole proprietorship, you don’t need to register the business if it’s under your legal name as an individual, but you must claim and pay tax on your income to the government. This is a pass-through taxation model where the income your business generates passes through you, the individual, and is taxed on your personal tax return. You can still claim work-related expenses in your deductions as a sole proprietor.
You might also choose to operate as an LLC, in which case, you must legally register a unique business name. An LLC is a hybrid model that’s part corporation and part partnership. LLC stands for limited liability corporation, which is the primary benefit of this model. By limiting your liability, you, as an individual, may be less likely to lose your personal assets if your business entity is sued for any reason. Also, the paperwork associated with an LLC is less complicated than other corporations, but you’ll still reap many of the tax benefits.