IRS Audit Reasons – Decide between a Hobby or a Business

Millions of people run a business that once was their hobby. We all develop our hobbies into some sort of professional activity. If you run a hobby business and report proper tax filing, you are safe. If you have invested significantly in a hobby, it incurs expenses. Many people make the mistake of not itemizing the deductions. Some fail to report any income generated from hobbies.


If you are a writer or photographer and you also sell your work, you enter into a self-employed category. Taxable income and deductions from a self-employed perspective are altogether different from hobbies.


The IRS provides key factors to consider before you decide on labeling a business as a hobby.

  • If you carry out the hobby in a business-like manner and keep accounting records of it

  • You intend to make money out of the hobby, e.g. selling raised pets

  • You invest significant resources into it such as time and money

  • You are dependent on income generated from the activity, i.e. it is your core activity for livelihood

  • Your activities generated profits in the previous years. Usually, profits in two out of five years previously

  • You invest resources to make profits such as advisors and managers

  • You plan to make profits out of the activity in the future

Simply put any significant activity that you don’t follow for pleasure or recreational purposes will fall into a business category.


Deductions for Hobby Expenses


You are allowed to deduct hobby expenses as much as you generate income from it. Simply put, your deductions for hobby expenses cannot exceed the amount you generated out of it. If you list more expenses than your hobby incurs a loss, that loss cannot be carried over to your tax returns.


What is allowed as a deductible?


Any relevant expenses that relate directly to your hobby are allowable deductions. You can either claim the standard deductions or itemized deductions.


Hobby Deductions – Itemized or Standard format


Tax filers can take the hobby deductions in either standard or itemized format. If you filed for an itemized hobby deduction before the tax year 2018, you can deduct the hobby expenses now.


Standard deductions can be categorized as filing returns and appropriate expense lines. Keep the expense deduction in line with your filing method such as single or joint tax filing. It will be a safer option to use Schedule C if you generate some income from the hobby.


Itemized deductions are 2% of the total adjusted gross income in the financial year. You can then deduct the calculated amount as deductions. For example, if your hobby generated $5,000 and your total AGI remains at $50,000, then your itemized deduction (2%) will be $4,000. (Calculated as: 2% × $50,000= $1,000, therefore deduction will be $5,000 – $ 1,000)


If you are investing significant resources and time, it will be a safer option to keep the records. You can then report these expenses and income from hobbies and other activities on Schedule C.


Deducting for Losses with Hobby


This is another red flag for the IRS. You have been investing in your hobby or any other leisure activity for several years. You have put in time and money with human resources to look after it. Then you report losses on Schedule C related to your hobby. That seeks immediate IRS attention.


It may happen that you invested for several years in a hobby, but reporting losses of business or any other income source against hobby expenses will land you in trouble. If you categorically term the hobby as a business, you can charge for all expenses and carry the losses forward as well.


Make sure to keep the expense receipts for hobby activities to justify if you get an IRS audit. Also, make sure you can justify the activity as a hobby. If you are not spending most of your time on it and do not expect to make future profits, you can justify the expenses as itemized deductions from the hobby.

Photo by Helena Lopes on Unsplash


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