Hobby vs. Business: Are You Safe from the IRS? (9-Point Checklist)
Selling pottery on Etsy? Streaming on Twitch? If you treat it like a Business, you get massive tax breaks. If you treat it like a Hobby, you might pay taxes on revenue without deducting a single cent of expenses. The difference isn’t how much you make—it’s how you act.
1. The “Hobby Loss” Trap
Many people think “I’ll just call it a hobby so I don’t have to deal with the IRS.” This is a mistake. Being a hobby is expensive because you pay tax on revenue, not profit.
| Scenario ($10k Sales, $8k Cost) | If “Hobby” | If “Business” |
|---|---|---|
| Report Income | $10,000 | $10,000 |
| Deduct Expenses | $0 (Usually*) | -$8,000 |
| Taxable Profit | $10,000 | $2,000 |
| Tax Bill (22% rate) | ~$2,200 | ~$440 |
*Why can’t Hobbies deduct?
2. The IRS 9-Factor Test
The IRS uses 9 specific factors (Treasury Reg. § 1.183-2) to determine if you are a legitimate business. You don’t need to pass all 9, but you need to show “Intent for Profit.”
A. Professionalism
- 1. Records: Do you use business software (QuickBooks) and have a separate bank account?
- 2. Expertise: Did you study the business model or hire advisors?
- 3. Time & Effort: Do you treat it like a job, not a pastime?
B. Financial History
- 4. Appreciation: Expecting assets (crypto, land) to grow in value counts as profit motive.
- 5. Success History: Have you successfully run other businesses before?
- 6. Income History: Are losses shrinking over time? (Startup losses are okay; perpetual losses are not).
C. Personal Motive
- 7. Occasional Profits: Even small profits help prove intent.
- 8. Financial Status: Do you need this income to survive? (Rich people running ‘fun’ farms are suspect).
- 9. Personal Pleasure: Is it purely for fun? (Fun + Loss = Hobby).
3. The “Safe Harbor” Rule (3 out of 5)
The IRS presumes you are a business if you show a profit in at least 3 out of the last 5 tax years.
Scenario: Establishing Safe Harbor
What if I fail the 3/5 test?
4. Strategy: How to “Prove” It
Don’t wait for an audit. Build your defense now by acting like a business.
- Separate Finances: Open a dedicated business checking account. Never mix grocery money with business supplies.
- Get an EIN: It’s free from the IRS. It signals “I am a business entity,” not just “Bob with a hobby.”
- Track Every Penny: Use software like QuickBooks Self-Employed. Hobbies don’t track receipts; businesses do.
- Change Strategy: If you are losing money, document that you tried to fix it (e.g., “Raised prices,” “Changed ads”). Hobbies accept losses; businesses fight them.