Hobby or business? How the IRS decides
Selling crafts, tutoring, reselling thrifted finds or taking photos for pay can be either a hobby or a business in the eyes of the IRS. The label matters a great deal. A business can deduct its expenses and, if it loses money, may be able to use the loss to reduce other income. A hobby cannot. This guide explains how the line is drawn and what to do about it.
Why the label matters
All income from a hobby is taxable, just as business income is. The difference is in the deductions. If your activity is a business, you report it on Schedule C, deduct your ordinary and necessary expenses, and pay self-employment tax on the profit. If it is a hobby, you report the income as other income, but you generally cannot deduct the expenses at all. The deduction for miscellaneous itemized expenses that once let hobbyists deduct some costs has been suspended since 2018, and 2025 legislation made that permanent. In exchange, hobby income is not subject to self-employment tax.
So a hobbyist who earns $3,000 and spent $2,800 on supplies and fees reports the full $3,000 as income and gets no deduction for the $2,800. A business owner in the same position reports $200 of profit. That is the difference in practice, and it is why the question matters most when your expenses are close to your income.
The IRS test: are you trying to make a profit?
The question the IRS asks is whether you carry on the activity with the real intention of making a profit. You do not have to actually make one every year. A new venture can lose money for a while. What counts is whether you are acting like someone running a business. The IRS looks at nine factors and no single one decides the matter.
- Do you carry on the activity in a businesslike manner? Do you keep complete books and records, a separate bank account, and make changes to improve profitability?
- Do you depend on the income for your livelihood? This is not required, but a stronger reliance on the income points toward a business.
- Do you have the time and effort to put in? Regular, substantial effort suggests a business. Using a lot of time does not by itself prove it, but little time can point the other way.
- Do you or your advisors have the expertise? Studying how successful operators do it, and consulting with experts, helps.
- Are you successful in similar activities? A history of turning ventures into profitable ones helps.
- Do the activity's assets appreciate? Property that may rise in value, such as land used in the activity, can support a profit motive.
- What is the history of income and losses? Losses in the start-up phase are normal. Continuing losses beyond that phase, without a reason, are a warning sign.
- Do you make occasional profits? Even an occasional big profit supports a profit motive.
- Do you take pleasure from the activity? Enjoying your work does not make it a hobby. But when the main attraction is recreation, the IRS may be skeptical.
The three-out-of-five-years presumption
There is a helpful safe harbor. If your activity made a profit in at least three of the last five tax years, the IRS presumes that it is a business and not a hobby. For activities involving breeding, training, showing or racing horses, the test is two profitable years out of seven. If you fall short, the presumption does not apply and the nine factors decide. That does not mean you lose. It means you need to be able to show a profit motive.
New businesses have a special option. Filing Form 5213 lets you postpone the IRS's decision on whether the three-of-five test is met until the end of the fifth year of the activity. This can keep the question open while you build the business, but it has consequences, including a longer period during which the IRS can review those years, so ask a professional before using it.
What businesslike behavior looks like
Because the test is about your intent and conduct, the evidence is in how you operate. These are signs that you are running a business, and are worth doing whether or not you ever get questions:
- Open a separate checking account and use it only for the activity.
- Keep records of every sale and expense. See recordkeeping for side income.
- Write a short plan: who your customers are, what you charge, how you expect to become profitable.
- Track results and change your approach when something is not working, whether it is pricing, marketing or costs.
- Advertise or have an online presence, set prices to cover your costs, and respond to customers like a professional.
- Get licenses, permits and insurance as required.
What if my business has a loss?
A true business that loses money in a year can generally use that loss to reduce other income on the return, like wages, subject to limits that include the at-risk rules, the passive activity rules, and a cap on very large business losses. For a typical side business with a small loss, that means the loss can reduce income tax on your wages, and in a start-up year that can be a real benefit. Self-employment tax is figured only on the business's own net earnings, so a loss means no self-employment tax on the side business for that year, but it does not refund the payroll taxes withheld from your wages. If the loss is large, or repeated, expect more questions, since the IRS watches for hobby activities that claim losses year after year.
An example of each
Maya sells handmade candles. She keeps a spreadsheet of sales, has a dedicated bank account and business insurance, pays for market stalls to find customers, adjusts prices after the first season, and made a small profit in two of her first three years. Her activity looks like a business. She files Schedule C, deducts her materials, booth fees and half of her phone bill, and pays self-employment tax on her profit.
Leo paints landscapes for his own enjoyment, sells one painting a year to a friend, never tracks costs, and spends several thousand dollars a year on trips to paint in scenic places. His activity looks like a hobby. He reports the sale as other income, and cannot deduct the trips or supplies. His tax bill is not subject to self-employment tax.
The same painter who starts entering shows, building a website, pricing against costs, and keeping records, over time, may become a business. The classification is based on facts and can change.
What to do next
If your side activity is a business, our guide to side-income deductions shows what you can claim, and our set-aside guide explains how much to save. If it is truly a hobby, report the income, skip the deductions, and you generally do not owe self-employment tax. If you are on the line, a short appointment with a licensed tax professional is inexpensive and can save you from guessing.
Run the numbers with the free calculator
Sources
This guide is general information, not tax advice. Tax rules change and individual circumstances differ. Confirm the details for your situation with the IRS or a licensed tax professional.