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Tax Obligations When a Hobby Becomes a Business

  • Business
  • March 18, 2015 | Ryan O'Donnell

The rise of the internet as the world's virtual shopping mall has afforded opportunities to anyone with a hobby, a computer, and a bit of motivation.

No longer is crocheting, crafting, and canning confined to little old ladies in rockers. A graphic designer selling their artwork on Etsy for additional income may enjoy sudden success when her artwork is featured and her Etsy income quickly becomes her primary income. A jewelry designer with a Shopify store may only work a few craft shows a year yet build up a large following on Facebook and watch as his sales take off.

In both cases, the seller will have much to consider as their side project turns into a profitable venture and their hobby turns into a business.

From Hobby to Business

As we've covered in a previous post, according to the IRS, classification of an activity as a business or a hobby comes down to more than just profit vs. loss. That being said, it is true that to qualify as a business, your hobby should have earned a profit in three of the past five years, including the current year. However, the IRS also takes the time to consider "Actions and Intentions". These include, but are not limited to, questions such as:

  • Does the time and effort you are putting into the activity indicate an intention to make a profit?
  • Are you dependent on income from the activity?
  • If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
  • Have you made changes to your methods of operation to improve profitability?
  • Are you knowledgable enough about the activity to carry on as a successful business?
  • Do you have a history of making a profit in similar activities?
  • Have you ever made a yearly profit from this activity?

It's actually possible for the aforementioned questions to be applied in a way that will result in your business becoming a hobby too. If you claim a net loss for too many years, the IRS may classify your activity as a hobby. This would prevent you from claiming losses related to your activities.

The Impact of Business Classification

No matter the route to success, it may comes as a surprise to artists, designers, or other hobbyists that they must adhere to tax regulations when their hobby becomes a business. Don't worry, however, there are advantages and disadvantages to registering your hobby as a business.

First, tax rates are higher for a business; however, business expense deductions may be offset against profits, which is not allowed when claiming hobby expenses.

Second, as your hobby transitions to becoming a business, it's likely your sales will begin to expand your footprint across the county. You may even begin hiring remote sales people or traveling to new states to market your wares. Any of these activities has the potential to create nexus in new states and increase the complexity of sales tax compliance. 

Third, while it may be quaint to think of your new business as your old hobby, it's important to be sure the IRS feels the same way. Once you have a business on your hands, it's important to follow the steps below to set your business up properly so you can continue avoid issues with the IRS or state taxing authorities.

Register Your Business Name

Congratulations, you're ready to get set up legally as a business! If you're selling goods under a specific name on Etsy or Shopify, it's a good idea to have your business name registered. You'll need to file a trade name certificate with your county or town clerk's office. From then on, you'll be required to use this business name on all tax forms and documentation.

Obtain a Federal Tax Identification Number

The best place to start with documentation is at the IRS website. Every business in the United States must have a unique federal tax identification number that will be used on all tax remittance forms. It's like a social security number for businesses. Visit the IRS website to find the application for a tax ID number (Form SS-4).

Register for Taxes

You'll need to know in which states you have nexus. This determines the states in which you need to register to collect sales tax. You'll also want to review usage taxes and business taxes in the state that you run your business. For help with how to get set up for proper sales tax collection, visit our collection of state sales tax guides.

File Your Schedule C

When filing your personal income taxes on Form 1040 each year, you'll also need to include a Schedule C. This form is used to report profits or losses from your hobby business where you were the sole proprietor.

Once you've set up your business from a legal standpoint you'll be able to get special tax advantages, such as business expense deductions for craft materials and supplies. Your taxable business may always feel like a hobby to you, and that's just fine. Keep up the good work, and enjoy the rewards of a successful enterprise.

Avalara Author
Ryan O'Donnell
Avalara Author Ryan O'Donnell