You have finally done it! You just hit “Publish” on your very first blog post . . . or you added your first listing to your Etsy shop . . . or you signed up for your very first craft fair . . . or you just sold a handmade purse to your friend! All of these things are so exciting!
When the novelty wears off, you might start to panic. Do I now have a business? Do I have to pay taxes? Do I need to register with the IRS?
This post may contain affiliate links. For more information see my disclosures.
Don’t hyperventilate just yet. You may, in fact, have a business . . . but you might just be a hobby. We must determine if you are a hobby or a business before we can even begin to answer all of your 1,000 other questions! (Don’t worry about those other 1,000 questions either, I’ll answer them all in due time!)
Hobby or Business?
Many businesses begin as a hobby. If you are a blogger or an Etsy seller, you may have started out just for fun. At what point does a hobby become a business?
The IRS has several questions for you to consider when determining if your activity is a business or a hobby. They are:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Does the taxpayer depend on income from the activity?
- If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
- Has the taxpayer changed methods of operation to improve profitability?
- Does the taxpayer or his/her advisers have the knowledge needed to carry on the activity as a successful business?
- Has the taxpayer made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
Profit Is the Key
The main focus of these questions is whether or not you are conducting the activity with the intention of making a profit. In IRS speak, “Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit.” Keep in mind that Profit = Revenue – Expenses. Learn more about the importance of profit here.
If you began your blog with the purpose of earning money and making a profit, you are a business. If you truly started your blog just for fun (but who are we kidding!), you might be a hobby . . . at least for now.
For crafters and Etsy sellers, it might be more difficult to begin as a hobby. Selling physical products usually necessitates collecting and remitting sales tax to your state. In order to collect and remit sales tax, most states require a sales tax license. In order to obtain a sales tax license, most states require you to register as a business. Each state has different rules, so begin by googling your state’s department of revenue for details on sales tax.
You Are A Hobby
Let’s say you looked at the questions from the IRS and determine that you are a hobby. Are you completely off the hook? Not exactly. If you are a hobby, you still must report your income on Schedule 1 of Form 1040 on your personal tax return. Unfortunately, if you are a hobby, you can’t deduct any of your expenses on your tax return. So keeping careful records is still important.
If you are uncertain as to whether you are a business or a hobby, you may decide to begin as a hobby and see where things lead. Maybe you thought your blog would make money, but that just hasn’t happened yet, so you continue on as a hobby until things change.
Because hobby income must still be reported on your personal tax return, from the very beginning, you must track your revenue. It’s also a good idea to track your expenses too. I recommend this because even as a hobbyist, it is still important to know how much your hobby is really costing you. It may be eye-opening to see how all those little expenses add up.
Remember, profit is the main distinction between a hobby and a business. Once your revenue begins to exceed your expenses, it’s time to think about filing as a business. And if you have been tracking your revenues and expenses from the beginning, you’ll be ready.
You Are A Business
We already discussed that if you started your blog or online store with the intention of making a profit, that you are most likely a business. Although there is some subjectivity in the early days as to whether your activity is a hobby or a business, eventually your financial data determines how the IRS classifies you.
The IRS does have a rule that may force you into either the hobby or business category. If you are a hobby, but you have had a profit (more revenue than expenses) in 3 of the last 5 tax years, then the IRS determines that you are not a hobby, you are a business. The IRS presumes that an activity is carried on for profit (as a business) if it makes a profit during at least 3 of the last 5 tax years.
This rule works the other way too. If you decide you are a business, but you do not have a profit in 3 of the last 5 tax years, the IRS determines that you are not a business, you are a hobby. In other words, if your business has had a loss in 3 of the last 5 tax years, then the IRS says that you are not truly operating as a business, you are merely a hobby.
You have concluded that your blog or Etsy shop really is a business and not just a hobby. What next? Selecting a business structure and registering your business are next on your list. Let’s get started on that!