Let’s say you have an unincorporated sideline activity that you consider a business. Perhaps you offer photography services, create custom artwork or sell handmade items online. Will the IRS agree that your venture is a business, not a hobby? It’s an essential question for tax purposes.

If the expenses from an activity exceed the revenues, you have a net loss. You may think you can deduct that loss on your personal federal income tax return with no questions asked. Not so fast! The IRS often claims that money-losing sidelines are hobbies rather than businesses — and the federal income tax rules for hobbies aren’t in your favor.

TCJA made tax rules worse

Old rules: Before the TCJA rules kicked in in 2018, if an activity was deemed to be a not-for-profit hobby, you had to report all the revenue on your Form 1040. You could deduct hobby-related expenses, such as itemized deductions for allocable home mortgage interest and property taxes. Other hobby-related expenses — up to the amount of revenue from the hobby — could potentially be written off. You had to treat those other outlays as miscellaneous itemized expenses that you could only deduct to the extent they exceeded 2% of your adjusted gross income (AGI).

Current rules: For 2018 through 2025, the TCJA suspends write-offs for miscellaneous itemized deduction items previously subject to the 2%-of-AGI deduction threshold. That change wipes all deductions for hobby-related expenses, except for expenses you can write off in any event (such as itemized deductions for allocable mortgage interest and property taxes). So, under current law, you can’t deduct any hobby-related expenses. As was the case before the TCJA, you must still report 100% of hobby-related income on your Form 1040. So, you’ll be taxed on all the income even if the activity loses money.

Determine if your activity is a business

Now you understand why for-profit business status is more beneficial than hobby status. The next step is determining if your money-losing activity is a hobby or a business.

There are two statutory safe-harbor rules for determining if you have a for-profit business:

• An activity is presumed to be a for-profit business if it produces positive taxable income in at least three out of every five years. You can deduct losses from the other years because they’re considered business losses.
• A horse racing, breeding, training or showing activity is presumed to be a for-profit business if it produces positive taxable income in at least two out of every sevenyears.

If you don’t qualify for one of the safe-harbor rules, you may still be able to treat the activity as a for-profit business and rightfully deduct the losses. You must demonstrate an honest intent to make a profit. Here are some of the factors that can prove (or disprove) such intent:

• You conduct the activity in a business-like manner by keeping good records.
• You have expertise in the activity or hire advisers who do.
• You spend enough time to help show the activity is a business.
• There’s an expectation of asset appreciation.
• You’ve had success in other ventures, which indicates business acumen.
• The history and magnitude of income and losses from the activity help show it’s a business. Losses caused by unusual events are more justifiable than ongoing losses that only a hobbyist would endure.
• If you’re wealthy, it may look like you can afford to absorb ongoing losses, which may indicate a hobby.
• If the activity has elements of personal pleasure, it may appear to be a hobby.

Don’t be discouraged

On the bright side, the U.S. Tax Court has, over the years, concluded that a number of pleasurable activities could be classified as for-profit business ventures rather than tax-disfavored hobbies. We may be able to help you create documentation to prove that your money-losing activity is actually a for-profit business that hasn’t paid off yet.

Is Your Money-Losing Activity a Hobby or a Business?

When you’re running a side hustle or passionately working on your craft, it’s easy to lose track of how much time and money you’re investing. Many people struggle with a crucial question that has significant financial and tax implications: Is this a hobby, or is it a business?

The distinction between these two classifications isn’t just semantics—it determines how your revenue (or losses) are treated by the IRS. If you’ve found yourself wondering where your side project lands, we’re here to help break this down.

What This Blog Will Cover:

• How to differentiate between a hobby and a business (yes, even if it’s money-losing for now)
• Why the IRS cares
• Key considerations to classify your activity
• Tips to make sure you’re doing it the right way

Why The Hobby vs. Business Debate Matters

At the heart of this discussion is taxation. Why does the IRS care so much?

Hobbyists can’t deduct expenses beyond what they earn, while business owners can deduct business-related expenses, even if they’re operating at a loss. For small business owners, this distinction can mean the difference between a hefty tax bill and potential deductions that actually help reduce your loss.

Here’s an example to help you visualize it:

• Case 1 (Hobby): You sell handmade candles on Etsy but don’t consistently aim to make a profit. You earn $200 but spend $500 on materials. The IRS considers it a hobby, so you can’t write off the $300 difference as losses.
• Case 2 (Business): You sell those same candles with a clear goal of turning a profit. Even though you’re currently at a loss, you may qualify to write off your expenses toward reducing your overall tax liability.

The IRS is particularly watchful of “money-losing activities” because some taxpayers might label their hobbies as businesses just to gain tax advantages.

How to Identify Whether It’s a Hobby or a Business

The IRS has specific guidelines to help classify an activity. Consider these nine factors to determine whether your activity fits into the “hobby” or “business” bucket.

1. Profit Motive

Do you genuinely intend to make a profit from this activity, or are you doing it mainly for personal reasons? Businesses typically show consistent efforts to earn money.

2. Time and Effort Spent

How much time do you dedicate to the activity? Hobbyists treat their crafts as leisure pursuits. Entrepreneurs often invest significantly more time to build their venture.

3. Dependence on Income

Is this income necessary for your living expenses? If so, that weighs in favor of it being a business.

4. Record-Keeping and Organization

Do you keep detailed financial and operational records? A business should always maintain organized documents of its sales, expenses, and activities.

5. Expertise and Efforts to Improve

Are you continuously learning, improving your craft, or adopting business best practices like marketing, networking, or scaling your product line? Hobbyists typically don’t approach their activity this way.

6. Past Experience and Success

A track record of running similar successful ventures or making efforts toward success with your current activity could indicate your intent to operate a business.

7. Frequency of Profitability

Do you make—and report—a profit at least three out of five years? Sustained unprofitability signals a higher chance it’s a hobby.

8. Financial Risk

Did you invest substantial amounts of money into the activity? Taking risks with the clear direction of moving toward profitability points to a business.

9. Enjoyment Isn’t the Main Motive

Yes, you can enjoy running your business. But if your primary goal is enjoyment rather than making money, it leans toward being a hobby.

Key Steps to Transform Your Hobby into a Business

If you’re reading this and realizing your “business” might actually come across as a hobby to the IRS, don’t worry. Here’s what you can do to ensure your passion project is classified as a business moving forward.

1. Develop a Business Plan

Even if you’re just starting out, outlining your strategy, goals, and revenue model demonstrates that you’re thoughtfully approaching your operation.

2. Separate Business and Personal Finances

Open a dedicated business bank account and use it exclusively for your business activities. Keeping everything separate ensures clear financial records.

3. Register Your Business

Depending on your state and operation size, registering your business—whether as a sole proprietorship, LLC, or corporation—adds credibility and shows intent.

4. Track Your Income and Expenses

Accurate bookkeeping is a must. Use software like QuickBooks or hire an accountant to document every expense, revenue source, and deduction.

5. Market Your Work

If your work isn’t visible, it’s harder to argue that you’re trying to scale it. Use social media, email campaigns, or craft fairs to expand your reach.

6. Be Patient, but Consistent

Every business faces challenges in the beginning. Make intentional decisions while keeping your ultimate goals in focus.

Finding the Sweet Spot Between Passion and Profit

Your side project doesn’t have to be a choice between passion and profit—it can be both. But you must treat your venture like a business if you want access to its financial benefits.

For entrepreneurs and small business owners, the hobby vs. business classification isn’t just about taxes; it’s about building something sustainable and impactful. If you’re crafting custom jewelry, baking artisanal goods, or creating content, the steps you take now can help secure your financial future.

Ready to Turn Your Hobby Into a Thriving Business?

At SD Mayer & Associates, we’re here to help you simplify this process. From offering guidance on business organization to keeping your finances in shape, we can help you lead your activity toward long-term success.

Still not sure where you stand? Book a consultation with one of our experts today. Together, we’ll determine if you’re ready to elevate your craft into entrepreneurship—or if it truly is your “just for fun” escape.