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If you work for yourself, either full time or as a sideline to a job as an employee, the net profit from your activity is taxable. That income is reported on Schedule C.
The interview for this issue will help pinpoint the expenses you can deduct to hold down the taxable profit and the tax bill. For advice on business income planning, please see Business strategies.
Income from sideline jobs is self-employment income and should be reported on a Schedule C. On the plus side, that will also permit you to deduct the cost of any materials you used, plus the cost of transportation to and from the jobs. If your self-employment income was more than $400, you also have to file a Schedule SE and pay Social Security and/or Medicare taxes on the income.
You've heard plenty about it: Play your cards right and you can convert your hobby into a sideline business and transform the cost of your avocation into tax deductions. An inviting idea, to be sure, and it can work. But the IRS isn't in the business of subsidizing your fun, which is why the hobby-loss rules are lurking in the tax law. You have to show that you're really out to make money, and at least occasionally show a profit, or the IRS will have nothing to do with the cost-sharing end of the arrangement.
Recognizing that profits are not automatic in any business venture, regardless of how hard you're trying to make money, the law does not demand that you show a profit every year for your endeavor to be classified as a business rather than a hobby. But you do have to make money in three out of five years to get the benefit of the doubt and deduct losses in the two profitless years. (If your enterprise consists primarily of breeding, training, showing or racing horses, you don't have to be as successful. Turn a profit two years out of seven to dodge the hobby-loss rules and qualify for business deductions.)
If you pass the test, the IRS can still audit your return and try to deny deductions, but it has to prove that you're not in business for a profit. When you fail, the burden of proof is on you to show that you really are trying to make money. And, the cards are stacked in the government's favor.
Profit from a hobby is always taxed; loss is never deductible. That does not mean none of your hobby expenses can be written off; just that the deductions are limited to the amount of income your hobby generates. Another catch, is that hobby expenses are considered miscellaneous itemized deductions. If your activity qualifies as a business, you deduct expenses in full on Schedule C, even if your costs exceed income. If it is classified as a hobby, though, not only are write-offs limited to the amount of income earned, but those allowed are deductible as miscellaneous expenses on Schedule A. You get deductions only if you itemize and then only to the extent that all your miscellaneous deductions exceed 2% of your adjusted gross income.
Don't let the restrictions discourage you from trying to blend money-making efforts into your avocation. The types of activities that often draw scrutiny from the IRS can be viewed as a list of opportunities as well as risks: free-lance writing; photography; painting; dog and cat breeding; stamp and coin collecting; raising flowers; boat chartering; and raising, showing or racing horses. If you are involved in those or any other activities that produce goods or services you could sell, consider mixing pleasure with profit, with the help of tax-saving deductions.
Say you're an amateur photographer, and you decide to try to capitalize on your skills by hiring yourself out to photograph weddings, birthday parties, award ceremonies, etc. You have business cards printed and buy ads in the local paper. You show your landscape photos at a gallery and sell several prints.
Your hobby has been transformed into a business. You have to report the income you earn, but you also earn deductions: for the cost of your film and processing, frames and mats, ads and business cards; the cost of getting to and from assignments, including food and lodging if you're away from home overnight; the cost of attending a photography seminar; and depreciation of your cameras and other equipment.
But what if, despite your best intentions and efforts, your costs exceed your income? Assuming you expect to turn a profit in the future and are running your activity in a businesslike manner, you can deduct the expenses even if you show a loss. If the IRS challenges your write-offs before you've had a chance to meet the three-of-five year profit test, you can ask the government to postpone its hobby/business decision until the end of the five-year period. If at that time the decision goes against you, you'd owe back taxes and interest.
Even if you lose on the three-of-five-year test, you can win the right to deduct losses if you can convince the IRS that you're really trying to make money. Among the factors that will be considered:
Whether you're managing the activity in a businesslike manner—keeping good books, trying to drum up business, holding down costs where possible, charging reasonable prices;
How much time and effort you devote to the business;
Whether you or your advisers have the expertise needed for the type of business you've chosen;
Whether following a loss one year you make changes in an effort to turn a profit in the future; and
Whether your profit expectation is based in part on expected appreciation of assets used in the business.
Thorough records are essential. If you are challenged, it's up to you to prove that your endeavor is a profit-motivated enterprise worthy of the tax deductions you have claimed rather than a hobby masquerading as a business.