Tax Advice for when a Hobby becomes a Business

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You baked cupcakes for family and they always loved them. You began to take orders for cupcakes from around the neighborhood and deliver them to neighbors. Is the activity a hobby or a business? Tax problems sometimes arise when taxpayers confuse a business for a hobby, or vice versa.

If you are making a profit from an activity and engage in it with the intention of making a profit, it is considered a business. Therefore, if you are selling cupcakes to make a profit, it is a business. On the other hand, if you are selling cupcakes with no profit margin and no future expectations of making a profit, it is not a business. Even if the business is not currently producing profit, if you are working in a manner that you hope will give you a profit at some point, it will be considered a business for tax purposes.

Taxpayers should consider these criteria when determining when they should consider their hobby a business:

  • Do you depend on income from the activity?
  • Do you put time and effort put into the activity with the intention to make a profit?
  • If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
  • Have you tried to improve profitability by changing methods of operation?
  • Do you or your advisors have the knowledge needed to carry on the activity as a successful business?
  • Have you made a profit in similar activities in the past?
  • Do you make a profit in some years?

Deducting Expenses

The deductions you can make for hobby activities are significantly different from those made for business. For hobby activities, allowable deductions cannot exceed the total amount made from the activity. This means, you cannot deduct more for your cupcake making supplies than you made selling the cupcakes.

For businesses, deductions can be made for the ordinary expenses and necessary expenses incurred. Any common expense or an expense that is expected to be incurred in running a business is an ordinary expense. For example, transportation costs for home delivering cupcakes would be considered a reasonable and ordinary expense.

A necessary expense is one that is expected and is appropriate for the business. It might not be an ordinary expense that is incurred almost every day or is expected to be incurred with a regular frequency, but that is considered appropriate for the business.

Tax Filing for Small Businesses

If your hobby has now become a business, you will need to file Form 1040, U.S. Individual Income Tax Return, Schedules C, E, F. Taxpayers may also file Form 2106, Employee Business Expenses. They may use Form 2106 if they were an employee during the tax year, and incurred job-related expenses that were not reimbursed by their employer. The expenses must be ordinary and necessary expenses incurred for the job.

Getting an EIN Number

The IRS has made it mandatory for every business, large or small, to have an Employer Identification Number (EIN). Even if you have one employee, you are required to get an EIN. It is used by the IRS to identify a business. You can apply for an EIN online for free. You will need to answer a few questions after which the IRS will make confirmations and assign the EIN. When filing taxes, you will need to enter your EIN on the tax return. Therefore, it is best to get one before the tax filing season.

From the author: Tax Resolution Legal Team
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