One of my best friends loves to bake cakes; she posts pictures of her cakes on Instagram and sells her cakes to anyone who would like a custom cake, which for now is mostly family members and friends of friends.
Baking cakes is her hobby. She’s not a bakery. She doesn’t have an industrial grade kitchen. She works full time as a CPA. But she does make beautiful cakes and turns a small profit. Unfortunately, her cakes do not generate enough income for her to even come close to quitting her day job (at least not yet).
Making the distinction between a business and a hobby is crucial for tax purposes because the tax treatment and deductions allowed differ significantly between hobbies and businesses.
The IRS gives businesses much more preferable tax treatment compared to hobbies. Businesses enjoy numerous tax benefits, including deductions for ordinary and necessary expenses like office supplies, wages, rent, and advertising costs. Depreciation allows businesses to deduct tangible assets' wear and tear over time. Business owners can offset losses against other income and deduct business-related travel expenses. These tax advantages make running a business a tax-efficient and strategic option.
Hobbyist or Business Owner
To prevent just anyone from taking tax deductions to fund their passion projects, the IRS weighs several factors to distinguish between a hobby and a business. Key considerations include the intention to make a profit, regularity of engagement, effort, expertise, financial investment, reliance on income, and a willingness to adapt for profitability.
No single factor is decisive, and the overall circumstances are evaluated. Over time, an activity may shift from a hobby to a business if the business-related factors become more prominent.
Even though my friend does all the business things – tracks her expenses, markets on Instagram, makes a small profit – her cake making is still a hobby because she doesn’t operate with regularity and she doesn’t depend on the income from her cakes even in the slightest. She truly does it because she loves it.
Tax Impacts
For hobbies, any income generated must be declared on your tax return as “Other Income,” but currently hobbyists aren’t able to deduct any of their expenses or even net their hobby income with their hobby expenses. This is a huge disadvantage of having a hobby.
Prior to the Tax Cuts and Jobs Act of 2017, hobbyists were able to deduct their hobby-related expenses (greater than 2% of AGI) as an itemized deduction. Unfortunately, that is no longer the case, at least until 2025 when the law is set to return to the pre-2017 rules. Losses related to a hobby have never been allowed – i.e., you could never deduct more money than you made – and that is still the case.
For example, when my friend sells a cake for $50, she is legally required to claim that $50 as income, but the $55 in flour, eggs, sugar, vanilla extract, food dye, equipment, decorations, etc. is non-deductible and there is no netting against her other income. My friend must pay taxes on the full $50 received for the cake, even though she technically lost $5.
However, if she were a business, she would be able to deduct that $5 loss against her CPA income – not paying taxes on the income from the cakes and also enjoying the benefit of offsetting other income with any business losses.
You may be thinking, “shoot – I should start a business in retirement”. And yes, you should if it’s an actual business and not a hobby. I caution you against calling yourself a business when you only have expenses because the intent to be profitable is a large factor in the IRS determination of a business. Also keep in mind that sole proprietors, especially those with large deductions, are more likely to be audited by the IRS.
