Is It a Business or a Hobby? Here’s How the IRS Decides (and Why It Matters)
Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or financial advice. The content provided is general in nature and may not apply to your specific situation. Tax laws, regulations, and interpretations change frequently, and the information presented may not reflect the most current developments.
Last Updated: May 2, 2025
If you’ve ever made money from a side activity, you’ve likely wondered:
Is this a business… or just a hobby?
It’s a crucial question because the IRS treats the two very differently when it comes to taxes. Getting it wrong could lead to missed deductions—or worse, an unexpected tax bill or audit.
In this guide, I’ll walk you through the critical differences between the business and hobby classifications and how the IRS makes its determination.
The Critical Difference Between Business and Hobby Activities
The IRS defines these activities with distinct characteristics:
Business: An activity pursued with the primary intention of making a profit
Hobby: An activity done mainly for personal enjoyment, regardless of occasional income
This classification affects everything from what expenses you can deduct to whether you'll pay self-employment tax.
The IRS 9-Factor Test
There’s no single factor that determines your activity’s classification. Instead, the IRS looks at the full picture using the following nine factors:
Business-Like Operations: Do you maintain separate financial records, have a business bank account, and follow a business plan?
Time and Effort: Are you investing significant time and effort into making your activity profitable?
Personal Enjoyment: Is the activity done primarily for recreation or personal pleasure?
Income Dependence: Do you rely on this activity as a primary source of income?
Past Success: Have you earned a profit in similar activities before?
Profit Expectations: Do you reasonably expect to make a future profit from the activity?
Profit History: Has the activity generated profits in some years?
Improvement Efforts: Have you changed your methods to improve profitability?
Financial situation: Do you have substantial income from other sources that might suggest the activity is recreational?
Important: The IRS generally presumes your activity is a business if you've earned a profit in at least three of the past five years (known as the "safe harbor rule").
Tax Treatment Comparison: Business vs. Hobby
Understanding these tax differences is essential for proper planning and compliance.
Business Tax Treatment
Income: Report on Schedule C of Form 1040
Expenses: Deductible
Losses: Deductible
Self-Employment Tax: Yes—subject to SE tax
Hobby Tax Treatment
Income: Report on Schedule 1, Line 8j of Form 1040
Expenses: Not deductible
Losses: Not deductible
Self-Employment Tax: Not subject to SE Tax
Pros and Cons of Each Classification
Business Classification
Advantages
✔ Can Deduct Business Expenses
✔ Can Deduct Business Losses
Disadvantages
❌ Subject to SE Tax
❌ Higher Likelihood of IRS Scrutiny
❌ More Extensive Documentation Requirements
Hobby Classification
Advantages
✔ Not Subject to SE Tax
✔ Simpler Recordkeeping Requirements
✔ Generally Less IRS Scrutiny
Disadvantages
❌ Can’t Deduct Business Expenses
❌ Can’t Deduct Business Losses
Key Indicators of Business vs. Hobby Status
Signs Your Activity is Likely a Business
Primarily engaged in activity for profit rather than personal pleasure or recreation
Operate in a Business-Like Manner (Separate Business Bank Account, Obtained Business Licenses, Formed a Legal Business Entity, etc.)
Use Professional Accounting Software like QuickBooks Online
Devote Significant Time & Effort into Improving Profitability
Activity Serves as Primary Income Source
Consistent Marketing and Advertising Efforts
History of Profits with Expectation of Future Profits
Signs Your Activity is Likely a Hobby
Primarily Engaged in Activity for Personal Enjoyment
No Bookkeeping or Organized Records
Work on it in your Spare Time
Not Dependent on the Income from the Activity
Not Actively Marketing or Growing the Activity
Consistent Losses Year after Year
Not Actively Trying to Make Changes to Operations to Improve Profitability
Why Proper Classification Matters
It is important to make sure that you classify your activity correctly.
Potential consequences of not classifying correctly include:
Owing back taxes, penalties, or interest
Overpaying SE taxes if your activity should be classified a hobby
Losing out on valuable deductions if your activity should be classified as a business
Triggering an IRS audit
Best Practices for Documenting Classification
Maintaining clear and consistent records is essential for demonstrating genuine profit intent for businesses.
Consider the following documentation practices:
Create and Follow a Written Business Plan
Use Professional Accounting Software like QuickBooks Online
Save All Customer Invoices & Business Expense Receipts
Keep Detailed records of all Income and Expenses
Maintain a Separate Business Bank Account
Track Time Spent on Business Activities
Document Efforts Made to Increase Profitability
Final Thoughts
The line between business and hobby isn't always clear-cut.
If you're uncertain about your activity's classification, start by seeing if your activity falls under the Safe Harbor Rule. If not, then evaluate it against the nine IRS factors or consider consulting with a tax professional.
By understanding these guidelines and taking appropriate actions, you can ensure you're classifying your activity correctly, maximizing legitimate tax advantages, and remaining compliant with tax law.
Free Download: Business or Hobby? IRS Classification Checklist
Still unsure how your activity stacks up?
We have created a simple checklist that will help you assess how your activity might be viewed by the IRS.
Download the Free IRS Business vs. Hobby Checklist
This checklist is perfect for solopreneurs, freelancers, and side hustlers who want peace of mind and clarity when it comes to tax time.
