Wondering if you are running a hobby or a business? This article will explain the finer details from a tax perspective.
Craft entrepreneurs often start their businesses with very small and irregular sales, so it’s quite common to think it’s more of a “hobby” type of activity rather than a fully fledged business.
It’s easy to find someone on the internet declaring that you don’t need to file taxes until you make a certain amount of money. This is a very popular misconception - the reality is that any online or offline selling activity in which the main motive is to make a profit is deemed by the IRS to be a business - this applies no matter how much you are making in revenue.
Here is what the IRS says:
An activity qualifies as a business if: your primary purpose for engaging in the activity is for income or profit, and you are involved in the activity with continuity and regularity.
So what does this mean? Essentially, if you are making products with the intention to make money, and you do this regularly then you are a business.
To illustrate the difference, let’s say you make a handful of Christmas cakes in December and sell to friends and family at a price that only covers your costs of manufacture. As you are not running for the sake of profit, you could conceivably argue that you are running a hobby activity in the eyes of the IRS.
Remember that the onus is on you to prove that your activity is not for profit, so if you are intending to keep running as a hobby you’ll want to ensure you have as much proof as possible of this. i.e. your manufacturing activity should be recorded in a way that you can demonstrate that you charged no more than cost.
If however you sell cakes through the year at a markup that results in a deliberate profit after expenses are removed, then no matter how many cakes you sell during the year or how much you made at the end of the day you should consider yourself running a business.
Hobby vs. Business Taxes
Many attempt to keep their selling activity under the banner of a “hobby” because they don’t want to file taxes.
If you are a hobby or a business, you will still need to file taxes to declare your earnings. The key difference is that as a hobby, you have very little ability to offset your profits against your expenditure.
Essentially, hobby businesses cannot deduct overall business losses. The only thing that can be deducted in this case is expenses, but only up to the amount of income you have earned.
Update: The new Tax Cuts and Jobs Act of 2017 has completely removed the Hobby Deduction for 2018 onwards.
Let’s say you start a cake baking business and in your first year you spend $150 on new cake tins and $300 on a mixer. In this same year, you only make $50 in sales. If you continue as a hobby, the most you can deduct is $50 to cover the sales you have made. That’s essentially $400 worth of deductions that you haven’t been able to make.
It’s even worse if you stock up on consumable materials when you first start out and continue as a hobby. Let’s say you buy $1000 of materials in year one and you make $50 in sales during the year. Whereas businesses can track material usage and assign it to future production via COGS, you as a hobbyist cannot do this. In this scenario, you can say goodbye to $950 worth of material deductions for your first year.
Proving you are running a business
Keep in mind that money making isn’t the only criteria for the IRS to consider when deciding if you are a business or a hobby. You essentially need to be proactively demonstrating that your business is valid.
One of the most important ways of doing this is to keep accurate and complete accounts of your bookkeeping. For a craft business, this includes tracking your inventory and claiming your costs of production via COGS. Craftybase is designed specifically for handmade sellers and includes both bookkeeping and inventory tracking features.
Please note that tax laws change frequently. This information is for educational and informational purposes only should not be construed as tax or legal advice. Please consult a licensed financial expert in your area with specific questions or concerns.