If you’re like me, you’ve been hearing fireworks going off pretty steadily in your Castle Rock neighborhood over the past week, culminating in the typical grand fanfare around the holiday. Except in parts of the country where fire and smoke have been major hazards — they’ve adopted drone shows (have you heard of these yet?).
Then there were all the fireworks in the headlines…
Last Friday the Supreme Court ruled on some pretty big things with some very heated, somewhat explosive reactions over the weekend. One of those big topics being Biden’s student debt forgiveness plan. It’s officially a no-go from SCOTUS.
Wherever you stand on that decision, the reality is, payments will resume August 30th and now there’s no debt relief on the table. So, while it’s been a nice reprieve to not pay those federal loans during economic trials, fitting it back in your budget is going to be a necessity.
There are good things that come from paying that debt down including a tax-related one called the Student Loan Interest Deduction. If you’ve been paying your loans despite the moratorium but haven’t been claiming this deduction, let’s make sure we clear that up during filing time.
Another thing you and I should be talking about come filing time: side hustles. More specifically, have you expanded a side business in the last few years that used to be more of a hobby? Usually, when you start a business, you need to be prepared to pay taxes as well.
But the line between hobby and side business can be a little fuzzy, more so in recent years because it seems like everyone has something on the side going on.
So let me bring some clarity to the subject…
When Your Castle Rock Hobby Becomes a Side Business to the IRS
“Where there is love and inspiration, I don’t think you can go wrong.” – Ella Fitzgerald
Do what you love, they say, and you’ll never work a day in your life.
Love it enough and do a good enough job, though, and sooner or later you have to think about taxes. But it can be a little unclear at what point your “hobby” technically becomes a “side business.”
…And how long you have before Uncle Sam starts asking, Where are your profits? And where are your income taxes?
Let’s find out — including what’s new in the legislation for this year and whether you should try to graduate to a “side business” at all.
True or false
Many people — especially in these days of the exploding gig economy — finally try their hand at making a few bucks in their spare time with an interest or outright obsession that they know somebody will pay them for eventually.
They also often embrace the notion that if you have business expenses, you can always deduct them on your taxes.
First, let’s establish something: The IRS is crystal clear on what makes a business and what makes a hobby. False.
The IRS book, Activities Not Engaged in for Profit Audit Technique Guide, admits “it can often prove highly difficult to figure out the difference between a legitimate business that is devoted to making a profit and an activity that is not.”
(As you can imagine, fuzzy language usually doesn’t help the taxpayer …)
Basically, though, when we say a hobby grows into a side business, we mean (for tax purposes) a small business. Small-business income, losses, and expenses are filed on the IRS Schedule C, “Profit or Loss From Business (Sole Proprietorship).”
Right now, business losses are deductible and losses from a hobby aren’t (though this might change a few years from now). So it’s important you qualify as a business — and that you can prove it — if you want tax deductions for losses and expenses.
Nine key details
So, how do you know? The IRS says you have a business if you …
- Carry out the activity “in a businesslike manner” and you keep complete and accurate books and records.
- Put in the time and effort to show you intend to make a profit.
- Depend on income from the activity for your livelihood.
- Suffer losses due to circumstances beyond your control or those normal for the startup phase of the business.
- Change operations to improve profitability.
- Have advisors with the knowledge needed to carry out the activity as a successful business.
- Were successful in making a profit in similar activities in the past.
- Make a profit in some years.
- Expect to make a future profit from the appreciation of the assets used in your activity.
(Note that none of the above nine is more important than the others. We can help you document all of them.)
As we said, if you do have a side business, you have to go through the time and trouble of filing (and justifying) your Schedule C. Generally, declaring a loss three years in a row is a sketchy red flag, and the IRS will disallow your tax deductions. This is also known as the “five-year rule.”
Keep this in mind
As well as those who try to declare businesses as loss ventures and take deductions too many years in a row are those who treat their Castle Rock business/hobby as a tax-free source of income. I can already tell you this is a bad move because the IRS is crystal clear on taxable income: If you make it, you pay tax on it.
Especially this year: If you make just 600 bucks in business income off the likes of eBay or you get paid at least that amount via PayPal, Venmo, and similar platforms, the IRS is going to know about it. You’re going to get an IRS Form 1099-K — and they’ll expect you to declare that money.
There’s been some legislation tossed around to increase that threshold to way more than 600 dollars, but so far it’s gone nowhere. We’ll keep you posted — and check with us to see if you should be paying estimated quarterly taxes or if you can have more withheld on your primary job to make up the taxes on your extra income.
So… hobby or side business? Can you deduct or not?
Here’s a very simplified guideline:
- Are you willing to have no deductions available and just pay taxes on whatever cash comes in? Hobby.
- Are you looking to make a profit, even eventually? Work many hours? Are you keeping good records of income and expenses? Business — with all the deductions, and responsibilities, involved.
We’re here to help with all your decisions about money and life. If you have a venture that rides the line between hobby and side business, reach out to us and we can look at how the IRS classifies it for tax purposes — and how to go about it in a way that’s most beneficial for you.
In your corner,
David Forney