Hobbies – Business Perspective and Tax Compliance

Many people turn their hobbies into a business operation. Not so much to make a living or make big profits, but more to help offset the costs of the hobby. Whenever you go to one of those community fairs, the vendors at the respective booths are mostly folks selling a product that is direct outcome of their hobby. The bands that play on stage, they make some money, but never enough to offset the cost of instruments, gear and transportation. But they enjoy entertaining folks and they hope someday they’ll get discovered. 

How do those folks involved in hobbies and earning some money account for their business? Also, how is the hobbyist dealt with by the Internal Revenue Service and the local government? This article will first explain the business aspect; then it will address the tax compliance elements of owning and operating a hobby.

Business Perspective

In business, there are three primary objectives, they are as follows:

 One – The number one objective or primary characteristic of any business is MAKE A PROFIT; this is why capital was originally invested. This is why somebody came up with an idea and decided to sell this idea. It doesn’t matter what it is, it’s driven by profit. You’ll hear about some companies that don’t state this as the first objective, but the reality is that the investors, current stockholders, and even the owner want the company/business to succeed. It is driven to make money.

Two – The second objective is to sell or make a product/service that is desired by as many people as possible. Whether you sell widgets or dig a ditch, you want to be the best and for your customers to talk about you in a positive light. PRIDE is at stake here, you want your company to be the best.

Three – The third characteristic of all business operations is to provide for the security and long term employment of the folks that support you, i.e. your employees. They work hard for you to make that profit and for you to enjoy that pride that comes with owning and operating a successful business. You want to take care of them. It benefits you and it is good for our society for people to work somewhere where they make a good living and provide for their families.

In the non-profit world, the three primary objectives are the same. However, they’re prioritized differently. The primary objective is to sell or make a product/service that is desired by as many people as possible. In general, hobby based businesses do not have employees so objective number three is irrelevant. However, the objective of making a profit is possible.  But with most hobbies, it is pretty much unlikely.

Most hobbyists enjoy entertaining or educating the public, sometimes they receive some compensation associated with the sale of a product or the service they render. But mostly, they do it because they are passionate about the subject matter.

For business purposes, most hobbies end up losing money at the end of every year. As the hobbyist, it is still your responsibility to track your receipts and your associated expenses. The goal is to minimize the losses each year. Whatever the excess of costs are over receipts comes out of your pocket. Try to operate the hobby as a legitimate business, but remember that it is still about having fun and doing what you enjoy even if it costs you some money each year.

If your hobby has some elements of risk involved such as a food preparation, contract compliance elements, or requires the assistance of employees; you may consider incorporating in order to protect your personal wealth. Read Why Incorporate? to better understand the value of asset protection. You should also discuss this with your legal counsel. 

Tax Compliance

As a business owner operating a hobby you must still comply with certain local and state laws. These include collecting sales tax for products sold and filing a monthly sales tax return with your state. If you are involved in delivering food of some sort, then most likely you are also responsible to collect and file meal tax returns. Most communities require some form of a business license or revenue return for all the receipts you collect. This is where the hobby based business is similar to the regular business. But it is different when referring to the Internal Revenue Code.

Under Code Section 183, hobby expenses are deductible up to the amount of the income generated. If your hobby had $3,200 of expenses and $1,950 of receipts, you are allowed to deduct $1,950 of those expenses. In effect, Congress doesn’t want the public to finance hobbies via tax relief in the form of lower taxes due to those losses. Now there are some other rules too. 

  1.  If your expenses for the hobby include taxes (revenue tax, state taxes or compliance taxes), they are deductible on Schedule A of your Form 1040. Continuing the example above. If you paid $75 in a revenue tax to your local government and another $30 for personal property taxes on some equipment associated with your hobby, you deduct these on your Schedule A. This leaves you with a balance of $3,095 in other expenses.  Again, $1,950 of these remaining expenses are deductible against the receipts you earned from this hobby.
  2. If any form of depreciation or amortization exists, read Depreciation – This is Weird Accounting for an understanding of depreciation, they are deductible only if receipts exceed expenses and then only up to the remaining balance of revenue in excess of expenses.

Now here is the best part: If your expenses are greater than your receipts, you don’t need to file any documents or forms with the IRS. In effect, they don’t want to hear from you. Why? Think about the volume of hobbies out there in this country that collect some monies and have expenses in excess. You would be surprised at the volume. Imagine the paperwork the IRS would have to handle to account for all of this. And for what, zero tax revenue? They use the term of de minimus value as justification for ignoring this area of the economy.

There are exceptions to this basic guideline. If you are operating under the corporate entity form, then yes, you will need to file a tax return even though you lose money year after year. The second guideline is the three out of five year rule. If you produce a profit in three out of five years, then the IRS expects you to file a return or a Schedule C with your return in each of those profitable years.  In effect, you have to be reasonable in your approach. If in the first two years you lose money and then make money in year 3, you need to file a return or Schedule as applicable in year 3.

If your hobby involves livestock or horses, the IRS presumes you are in business and a tax return or schedule as applicable is required even if you lose money.

Summary – Hobbies

Hobbies in the business world serve two good purposes. It makes those conducting the hobby happy and it helps society by continuing to serve us and maintain the cultural customs and values associated with providing these items. In general, most hobbyists do not make a profit due to the nature of the product or service. However, it is still a good idea for the hobbyist to track their respective revenue and associated expenses. Local and state governments do require compliance as if operating a business but the IRS only requires documentation when the hobbyist makes a profit. Act on Knowledge.

Value Investing

Do you want to learn how to get returns like this?

Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.

There are four key principles used with value investing. Each is required. They are:

  1. Risk Reduction – Buy only high quality stocks;
  2. Intrinsic Value – The underlying assets and operations are of good quality and performance;
  3. Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
  4. Patience – Allow time to work for the investor.

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