Some people think that a freelance business is really a hobby if you work from home, but is it? What about if you keep unusual business hours or work part-time? Do these things mean you’re not really in business?
Some so-called gurus say that working from home or keeping unusual hours means you don’t have a real business.
While many people may have their own opinions about what makes up a business, in many countries there is an actual legal answer to the question. In the United States, that answer comes from the Internal Revenue Service (IRS).
It’s important to get the right answer to this question, because it has broad implications regarding your taxes and bookkeeping. In this post, we’ll discuss this important topic and provide some additional resources that you can turn to with questions.
Are You Trying to Earn a Profit?
(Information provided here is based on available information at the time it was written and should not be considered legal or tax advice. For your specific situation, consult with a legal or tax specialist.)
This is the main question that the IRS wants to know when deciding whether your activities should be a classified as a business or a hobby. To determine this, they will first look at your last five years of business (including the current year). If three of those years (including the current year) show a profit, then the IRS will most likely consider that you have a profit motive.
With creative people (and that includes many freelancers) the line between a business and hobby can sometime be blurry. Sometimes what started out as a hobby can transition into a business, so it’s very important to understand the rules.
Can You Be Unprofitable and Still Be a Business?
You may think that a string of unprofitable years means that your business will automatically be reclassified as a hobby, but that isn’t necessarily the case. You may still be able to demonstrate that you have an intent to earn a profit even if your business has not earned a profit yet.
To demonstrate a profit motive for your business, first of all make sure that you keep excellent records. It may help your case if you can provide some of the following information:
- The amount of time you put into the business
- The percentage of your total income that comes from the business
- The reason for any losses
- Changes and improvements you’ve made to the business
- Evidence of your own knowledge in the field
- A record of any past business successes including any profits made in earlier years
- The current and anticipated future value of any business assets
It should go without saying that you should be keeping excellent bookkeeping and tax records. If this is not your strength, you may need professional accounting help.
There are some legitimate reasons why a business might have an unsuccessful year, so don’t panic if your business had an unprofitable year.
What If My Activities Are Classified a Hobby?
What happens if, despite your best efforts, the IRS reclassifies your freelancing business as a hobby?
As I mentioned earlier, there are some implications for your taxes and bookkeeping–the main one being that there is a limit to deductions for expenses related to hobby activities. Specifically, loses from your hobby cannot be used to offset other income. These deductions appear on Schedule A of the 1040. There are also certain business deductions, such as the deduction for start-up expenses, that do not apply to a hobby.
For freelancers in the U.S., the best place to get more information and the most updated information is on the IRS website. Here are three IRS publications you may wish to review:
Here are some other excellent resources that help explain the difference between a hobby and a business:
- Is Your Business Just A Hobby In The Eyes Of The IRS? This post from MyWifeQuitHerJob.com does a good job of explaining the difference between a hobby and a business.
- This post detailing 5 Common Business Tax Myths from About.com’s Small Business Canada guide discusses the issue from a Canadian perspective.
The actual reason I wrote this post is because I saw a tweet on Twitter with misinformation about what constitutes a business. The tweeter was sharing their opinion, but I knew from prior research that their opinion in this instance was wrong. This is one area where it’s not enough to simply have an opinion–it’s important to get this right.
I based this post mostly on information available for U.S. freelancers. However, other countries may have their own specific rules about what determines a business. If you’re a non-U.S. reader, share the rules in your country in the comments.
If you’re in the U.S., have you turned a hobby into a business? Share your tips in the comments.
Image by wachovia_138