Many taxpayers are surprised to find out that the IRS taxes hobby income. We all have hobbies. Yours might be painting, making unique juices, or growing flowers. Hobbies are an activity, or “side hustle” that is done mostly for pleasure rather than to profit. The IRS requires taxpayers to report hobby income as taxable income. For example, if a taxpayer whose hobby is making juice sells a few bottles, they should report those proceeds as hobby income on their return. Hobbies are something that might make money but the activity wasn’t performed with the intent to profit. In contrast, a business is something taxpayers enter into to make money. The IRS treats hobbies and businesses differently for tax purposes and has issued guidance to help taxpayers differentiate between the two types of activities.
Hobby vs. Farm – Why is the difference important for taxes?
Before we discuss how the IRS differentiates a hobby versus a business, it is important to understand the tax consequences of a hobby versus a true, bona fide farming business. As mentioned, the IRS requires taxpayers to report hobby income on their tax return. This income is taxed as ordinary income and is not subject to self-employment tax. Unfortunately for taxpayers, deductions for hobby expenses are disallowed as part of the changes in the Tax Cuts & Jobs Act of 2017. This means that if a taxpayer has a farming hobby, they are not allowed to deduct the cost of seed, fertilizer, etc. As previously mentioned, the income from a farming hobby is reported directly on page 1 of Form 1040. In contrast, farming businesses report activities on Schedule F of their tax return. Unlike a farming hobby, farming businesses are allowed to deduct qualified ordinary business deductions from farming income.
IRS Guidance & Tests
The IRS has issued multiple instances of guidance to assist taxpayers in determining whether their activities are a hobby or a business. In IRS Publication 225: Farmer’s Tax Guide, the IRS lists nine factors to consider in evaluating whether you are operating a hobby or a business. See the official nine factors below as well as my analysis and commentary on each factor that follows:
- You operate your farm in a businesslike manner – Taxpayers should evaluate whether their hobby has an EIN, a separate bank account, a budget, business plan, etc.
- The time and effort you spend on farming indicate you intend to make it profitable How many hours on average did the farmer spend on this hobby? What steps were taken to enhance profitability? Documentation of hours spent & activities performed is paramount.
- You depend on income from farming for your livelihood Does the taxpayer & their spouse have full-time jobs? Were those jobs in the farming industry?
- Your losses are due to circumstances beyond your control or are normal in the start-up phase of farming Was the taxpayer’s business impacted by a hurricane or other natural disaster? How big of an impact did COVID-19 have on profitability? If this is a farming hobby, have fluctuating commodity prices increased the hobby losses?
- You change your methods of operation in an attempt to improve profitability Taxpayers should ensure clear documentation of any steps taken to increase profitability or minimize losses. This could be adding new sales channels or changing suppliers.
- You, or your advisors, have the knowledge needed to carry on the farming activity as a successful business Does the taxpayer have knowledge of this field from prior jobs or experience? Is this activity similar in nature to their full-time job? Is the taxpayer involved in any trade groups or have they attended any education conferences?
- You were successful in making a profit in similar activities in the past Has the taxpayer had previous income-producing activities?
- You make a profit from farming in some years and the amount of profit you make Has the taxpayer made a profit from these activities in the past and if so, how much was the profit in comparison to the loss years? Was the deviation very small?
- You can expect to make a future profit from the appreciation of the assets used in the farming activity. Perhaps the hobby is simply finding assets (ex: rare collector's items) that will appreciate in value. How reasonable is the assumed appreciation?
No one factor in the above list is conclusive. Rather, taxpayers should consider all of the factors in the evaluation. Taxpayers whose only financial support comes from farming should feel relatively confident that their activities are a business. Uncertain taxpayers should seek professional assistance and document their evaluation of the nine factors mentioned above.
Another test that taxpayers can use to assist in the evaluation is looking at the historic profitability of the activities. If the farming activity has produced a profit in at least three of the last five tax years, the activities can be presumed to be a business for tax purposes. For horse breeding and racing, the IRS looks to whether there has been profit in two of the last seven years. If an activity fails this test, it does not mean the activity is a business. Taxpayers should evaluate the entire list of nine factors in regards to the historic losses. Failing the three out of five-year profitability test can lead to the IRS taking a closer look at the business or hobby activities.
Because of the ability to deduct expenses, there is a major benefit to treating a taxpayer’s activities as a business. Taxpayers should document their evaluation of the nine factors and keep a running record of their historic profitability. As mentioned, if a taxpayer’s sole activity is farming and it’s the primary financial support for the family, the activity is probably a business for tax purposes. The determination becomes much more difficult when taxpayers garden in their spare time or have a side hustle mostly for fun.
This article should not be construed as, and should not be relied upon as legal or tax advice.
Tyler Davis works for SVN: Saunders Ralston Dantzler real estate and also owns his own CPA Firm, Tyler Davis CPA where he provides tax preparation, consulting, and provision services. SVN: Saunders Ralston Dantzler is a leading agricultural land brokerage based in Lakeland, FL. Tyler can be contacted at firstname.lastname@example.org