The old adage about do what you love, and you'll never work a day in your life didn't consider the role of taxes when turning hobbies into businesses. Whether a taxpayer's activity is a business or a hobby can potentially affect their taxes and tax liability.

The IRS defines a hobby as an activity a person pursues for enjoyment and not for making a profit. Businesses, in comparison, are activities that are engaged in for the purpose of making a profit.

For example, a woman loves baking and makes cakes for friends and family. Given the expense of ingredients and equipment, she bills friends and family for her creations. She still charges below retail costs. Is she operating a business or merely covering expenses for a hobby?

The IRS has several factors to consider when deciding whether an activity is a business or a hobby. These include, to name just a few, the extent of a taxpayer's bookkeeping, the role (if any) of profitability with the activity, and how much a taxpayer depends on income from that activity to cover their expenses.

Whether an activity is a business or a hobby determines what forms a taxpayer files. Income from a hobby is generally reported on a 1040, whereas business expenses often require separate forms or even a separate tax return from an individual's personal return. The bigger issue, however, is that an activity's classification determines the ability of a taxpayer to deduct expenses.

Classifying a Business as a Hobby

In some cases, even when a taxpayer files a return that lists an activity as a business, the IRS may classify it as a hobby. This can be due to a lack of income, repeated annual losses, or other factors.

When the IRS changes an activity's classification, it alters what deductions a taxpayer can take. Since 2018, taxpayers cannot claim a deduction related to hobbies, which means they will likely face higher tax liability if the IRS believes a business is a hobby.

Going back to the baker example, if the taxpayer is operating a business, she can potentially deduct expenses related to the equipment she uses, purchases of additional equipment, and potentially training for classes she takes at a local culinary school, to name just a few ordinary expenses. If, however, baking is a hobby, she cannot take any of these deductions.

Get Help From an Experienced IRS Tax Controversy Attorney

If you have questions about how the IRS classifies businesses and hobbies, call Senior Partner, Tax Controversy Attorney, and former IRS attorney Brandon A. Keim at (602) 200-7399 or contact him online to discuss your options.