Business vs. Hobby - US taxes

[inquisitive]

Have been reading a lot about taxes, and regardless of whether an activity would qualify as a business vs. a hobby, it seems to me that if one is making a profit from the activity (income - expenses), one would want to classify it as a hobby, and if there is a loss, then one would want to classify it as a business?

Eg if one has net income, you don't want it to be a business because then you have an additional roughly 7.65% SE tax, and I can't see how this would be advantageous even with additional business deductions. And if there is a loss then you want it to be a business so you can use the loss against other income.

The only exception I can see to this is that if one makes more than $117,000 in other income (eg W2), then the social security tax is phased out and it would make more sense to have a business in order to use certain business deductions. Is this summary correct? I haven't seen anyone discuss it in this way in any book or article, but it seems like this is the only way to conceptualize it that makes sense.

 

[frayne]

Straight from the horse's mouth: Business or Hobby? Answer Has Implications for Deductions

 

[Texas Proud]

You might not have the final say on whether it is a business or hobby... if it is small, then you probably will not be audited.... if large.... better chance...


And the size of the activity does not come into play... back when I did taxes (35 years ago).... there was a rich guy who bred dogs... had income in the hundreds of thousands of dollars... but expenses always exceeded income... when audited the IRS said it was a hobby and disallowed a good number of deductions.... also, loss was not used to offset other income so he had to pay a lot of taxes...

 

[frayne]

I've always heard a good rule of thumb to differentiate the two is if are claiming a business and you have losses for three years in a row, why are you still in business.

Also as far as SE taxes it is closer to 15%, medicare and social security.

 

[inquisitive]

I'm not trying to distinguish the 2, stated "regardless of whether an activity would qualify as a business vs. a hobby," I'm wondering which would be advantageous to claim, realizing that there are specific criteria for the two that I would have to meet.

The SE tax becomes much less than 15% for self-employed individuals because it's taken on 92.35% of the qualifying income and you can take half of the SE tax as a deduction, so it's closer to 7%:

Tax Deduction for Self-Employment Income

Also the social security part drops off after $117,000 of income.

 

[target2019]

I'm not trying to distinguish the 2, stated "regardless of whether an activity would qualify as a business vs. a hobby," I'm wondering which would be advantageous to claim, realizing that there are specific criteria for the two that I would have to meet.

The SE tax becomes much less than 15% for self-employed individuals because it's taken on 92.35% of the qualifying income and you can take half of the SE tax as a deduction, so it's closer to 7%:

Tax Deduction for Self-Employment Income

Also the social security part drops off after $117,000 of income.

Distinguishing the two is actually the point of departure. You decide whether you are doing "this" for a hobby, or for business. Then you enter the yearly requirement to account for it.

I don't think you can look at just a few factors and decide which is more advantageous. Just venturing a guess, but I probably deal with at least two dozen categories of business factors in my small business.

For instance, to offset the SE tax, look at the impact of a retirement plan. I invest 20% of my profit for over 20 years, and have a nice tax-advantaged cornerstone to retirement. That is one major consideration, IMO.

 

[photoguy]

It seems to me that it would be pretty obvious to the IRS if you are running a business or hobby during an audit regardless of what is claimed. I would not try to mis-represent my activity.

 

[inquisitive]

Distinguishing the two is actually the point of departure. You decide whether you are doing "this" for a hobby, or for business. Then you enter the yearly requirement to account for it.

I don't think you can look at just a few factors and decide which is more advantageous. Just venturing a guess, but I probably deal with at least two dozen categories of business factors in my small business.

I disagree with this completely. Per the IRS, the most important factor in determining business vs. hobby is the intent, ie if there is a profit motive. I can decide if I want to do an activity as a business or a hobby, and as you have pointed out, there are many factors and not a few that goes into this designation. In addition you can expect there will be differences in time spent, approach, bookkeeping, etc, etc if it is a business vs. a hobby. Eg, if one is consistently having losses, one is going to have a hard time justifying it as a business.

This is also important in thinking ahead. If one is not pursuing the activity yet, it is neither a business nor a hobby.

For instance, to offset the SE tax, look at the impact of a retirement plan. I invest 20% of my profit for over 20 years, and have a nice tax-advantaged cornerstone to retirement. That is one major consideration, IMO.

Great point.

 

[inquisitive]

It seems to me that it would be pretty obvious to the IRS if you are running a business or hobby during an audit regardless of what is claimed. I would not try to mis-represent my activity.

If one or the other is "pretty obvious," then only one of them is correct and should be claimed. But there are a lot of gray areas, and if you have looked at briefs of court cases, you will see that it is anything but clear. But I do not want to derail this thread, I specifically stated in the first post that it was not about whether something qualifies as a business vs. a hobby, that discussion could take up pages and pages and in addition to IRS publications and coverage in books/articles, there is also a history of court cases on that subject. This information is mostly clear, was looking to have a different discussion.

 

[clifp]

If one or the other is "pretty obvious," then only one of them is correct and should be claimed. But there are a lot of gray areas, and if you have looked at briefs of court cases, you will see that it is anything but clear. But I do not want to derail this thread, I specifically stated in the first post that it was not about whether something qualifies as a business vs. a hobby, that discussion could take up pages and pages and in addition to IRS publications and coverage in books/articles, there is also a history of court cases on that subject. This information is mostly clear, was looking to have a different discussion.

Looking at it strategically, I think your post is correct. No reason to pay the SS tax (wouldn't it be double 7.65%?) and so treat it as a hobby.

However, I would guess a somepoint the IRS could challenge your hobby if it grossing multi millions and employees several people.

Likewise claiming it is business if you have a loss also makes sense, but again I thought you had to make a profit 2 years out of 5 also.

 

[target2019]

I disagree with this completely. Per the IRS, the most important factor in determining business vs. hobby is the intent, ie if there is a profit motive. I can decide if I want to do an activity as a business or a hobby, and as you have pointed out, there are many factors and not a few that goes into this designation. In addition you can expect there will be differences in time spent, approach, bookkeeping, etc, etc if it is a business vs. a hobby. Eg, if one is consistently having losses, one is going to have a hard time justifying it as a business.

This is also important in thinking ahead. If one is not pursuing the activity yet, it is neither a business nor a hobby.

Not sure we are understanding each other. What I said/meant to say:
The individual decides whether to embark on the hobby or business path. That's the point of departure. That's where intent begins.

I think we are in agreement. But maybe not.

To the OP, you might consider that the SE Schedule C and various IRS rules and publications are germane to figuring out which is more advantageous - hobby or business. It's a slippery slope for sure.

Perhaps look for some case studies of successful hobbyists and self-employed persons, and learn of the advantages from those types of reports.