When should a business be a hobby?
The federal tax benefits for running business are large and well known. Businesses are allowed deductions on federal income taxes for ordinary and necessary expenses, owners of businesses are allowed qualified business interest deductions, businesses are allowed bonus depreciation, section 179 deductions for certain property put into service, and so on. Given the many benefits available to running a business, it might surprise you to learn that many people have taken the position with the IRS that their activity was not a business but a hobby. See Batok v. Commissioner, T.C. Memo. 1992-727 and Spiegelman v. Commissioner, 102 T.C. 394 (1994). In those cases, the taxpayer argued the activity was not carried with continuity or regularity. Id.
To be clear, there are more factors which courts and the IRS consider whether an activity can be considered a business or a hobby. Recently, the U.S. Tax Court issued a decision in Young v. Commissioner, which went over what the IRS considers when characterizing an activity as a hobby or a business. See Young v. Comm’r, T.C. Memo. 2025-95.
In Young, the court explained one of the inquiries used to determine if an activity is a hobby or a business is if the activity was engaged with the intent to make a profit. Id. at 25. The intent to make profit must be in good faith but need not be reasonable. Id. To be clear, an activity does not actually have to make a profit. It just must be carried on with the intention of making one. Citing Treas. Reg. § 1.183-2(a) the court listed the nine non-exhaustive factors that are considered when determining whether an activity was intended to make a profit. Id. Those factors are:
(1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or the taxpayer's advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on similar activities; (6) the taxpayer's history of income or loss with respect to the activity; (7) the amount of occasional profits, if any; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation are involved.
The likely reason why the taxpayers in the tax court cases which characterized their activity as a hobby as opposed to a business is to avoid self-employment tax. Income from hobbies is not subject to self-employment tax (federal income tax still applies to hobbies).
Another reason why a taxpayer might be alright with characterizing their activity as a hobby is if their expenses are the costs of goods sold. While it is true as general manner hobby expenses are not deductible on federal income taxes, costs of goods sold are subtracted from gross receipts in order to calculate gross income. Thus, if an activity’s only costs are costs of goods sold, losing out on the business expense deduction is minimal.
Another reason why a taxpayer might want to characterize their activity as a hobby is if they are receiving a benefit which is income dependent For example, if you are under full retirement age social security benefits will be reduced if a tax payers earns wages above $24,480 if they reach retirement age after 2026 (it is $65,160 if they reach retirement age in 2026).
What does this mean for artists, musicians, and other aspiring entrepreneurs? It is important to check in with a tax expert as you start a new venture. There may be a basis to characterize it as a hobby and achieve a greater benefit than if it were characterized as a business.