How to Avoid a Tax Disaster with Hobby Income

How to Avoid a Tax Disaster with Hobby Income

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For many people hobbies are a source of income. From crafts, eBay sales, soap making, playing in a band to selling Mary Kay, these activities can be sources of both fun and finances. It is a great way to test your ideas and determine if you have a business opportunity.

Whether you have a hobby or business, the IRS wants you to report that income. The new tax laws that went into effect in 2018 has created a tax disaster. It will cost you even more now in taxes. As of January 1 2018, you can no longer report the expenses associated with your hobby. Higher taxable income – higher taxes. In addition to income taxes, your income will most likely be subject to self-employment taxes. This could result in a tax rate of 18% to 47% of the gross income.

Based on this potential negative outcome it is best to avoid being defined as a “hobby” and know the rules. The IRS uses nine factors to determine if your activity is a hobby or business. No one factor alone is decisive.

Here are the nine factors:

  • Do you carry on the activity in a businesslike manner and maintain complete and accurate books and records?
  • Is the time and effort you put into the activity indicate you intend to make it profitable?
  • Do you depend on income from the activity for your livelihood?
  • Are your losses due to circumstances beyond your control (or are they normal in the startup phase of your type of business).
  • Do you change your methods of operation in an attempt to improve profitability?
  • Do you or your advisors have the knowledge needed to carry on the activity as a successful business?
  • Were you successful in making a profit in similar activities in the past?
  • Will the activity make a profit in some years and how much profit will it make?
  • Do you expect to make a future profit from the appreciation of the assets used in the activity?

If you are going to partake in a potential hobby, it is critical to take the following steps:

  • Treat the cash as a business – have a separate checkbook and maintain a set of financial records.
  • Write a business plan that determines how and when you will make a profit. For example – you have a product you are developing, plan how you will bring it to the market and make a profit on it. If you have planted trees for a Christmas tree farm, note the activity for each year, your investments and the sale.
  • Learn more about how to make a profit – hire advisors, subscribe to magazines, attend a seminar, etc.
  • Document your time and actions to generate a profit.

Last but not least the IRS has a “safe harbor” method. To meet the safe harbor, an activity must generate a profit in at least three of five years ending with the tax year in question. At that point, the IRS has to prove that there is no intent to make a profit.

Starting a business part time is a great way to test your idea. However to avoid a tax disaster and to minimize your taxes be aware of the rules. Having a proactive accountant will keep the cash flowing and help you develop your hobby into a full fledge business opportunity. Happy dreams…

By Mary Guldan-Lindstrom, CPA

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