Many business owners started off with a hobby that became a business over time. Some people set out with the intention of building a business from their hobby while others are pleasantly surprised to discover there is opportunity to make a living from their passion. Whatever the motivation, it’s important to know when a hobby is still hobby and not quite a legitimate business yet. This is because businesses are allowed to deducted operating expenses from their taxes but individuals making additional income from their hobby cannot.
So do I have a business or a profitable hobby?
The IRS offers a set of guidelines that can help you figure out if your hobby has transformed into a business. If you have the skills and background to run the type of business you want to, you’re working with the intention of generating a profit, and you depend on the income, there is a good chance you’re operating a business.
But the IRS guidelines may still leave you feeling uncertain. Maybe you enjoy teaching exercise classes after work but don’t depend on the income because you’re already gainfully employed. And does running an ecommerce business on Amazon or Ebay actually require any special skills?
A more objective way to determine if you have a legitimate business or not is by applying what’s often called the "3 out of 5 test.” The IRS will view your operation as an income-driven business if you’ve made a profit from it in three of the last five years, one of which must be the present year. This means in your first five years of operation, you can have two years where you lose money or break even, which is not uncommon for businesses in the startup phase.
If you don’t pass the “3 out of 5 test” or haven’t been in operation for five years yet, it doesn’t necessarily mean you’re not running a business and can’t claim operating expenses. In this case, you should speak with a tax accountant who can take a look at your situation and recommend the best course of action.
What can I do to turn my hobby into a business?
Deciding to pursue your passion and turn your hobby into a business is exciting. In order to be successful, you should of course set out with the goal of running a profitable business. But you should also take all the necessary steps of opening a new business, including:
- Keep accurate and up-to-date financial records
- Open a business bank account
- Decide on a legal structure
- Get any necessary licenses and permits
- Purchase insurance
- Obtain a tax ID number and register with state and local tax agencies
Following these tips helps ensure your business gets off on the right foot. It also shows the IRS you intend to run a legitimate business.
BookKeeping Express (BKE) offers full-service bookkeeping for different types of businesses. Visit our features page to learn how we can help you setup your books and keep track of your finances.