Because a sole proprietorship doesn’t require the creation of any formal business entity, it isn’t necessary to convert a business from a sole proprietorship to a hobby. There are, however, significant differences in your federal income tax filings if you determine that your activities relate more to a hobby than a profit-seeking business.
Business or Hobby Income
The main distinction between a sole proprietor business and a hobby is your motivation for engaging in the activity rather than the earning of profit. Generally, you’re a sole proprietor if your intention is to earn income, regardless of whether you earn it or not. On the other hand, an activity is a hobby if you do it because of personal enjoyment and satisfaction. However, it is possible to earn some profits and still classify your activity as a hobby. Some situations constitute gray areas, but the IRS provides a number of factors you should consider before making a final determination as to whether you should file your taxes as a sole proprietor or not.
Factors to Consider
The first thing you should consider is whether you rely on the income from the activity to support yourself. If the activity provides sufficient income for you, regardless of how much you enjoy doing it, it resembles a sole proprietorship more than a hobby. Also important is the amount of time you dedicate to the business or hobby. For example, if you have a full-time job but make birdhouses on the weekends that you periodically sell at garage sales, the IRS is likely to consider it a hobby, because most of your time is dedicated to your job. You can also consider the consistency of the profit, the level of knowledge necessary and whether your costs relate to the normal expense of starting a business or are incident to a leisure activity.
Sole Proprietor Tax Implications
If you determine that you’re operating a business as a sole proprietor rather than pursuing a hobby, the IRS allows you to deduct all of the expenses you incur that are ordinary and necessary to support your business operations. This will require you to file a Schedule C or C-EZ with your personal tax return. The purpose of these schedules is to separately report your earnings and deductible expenses from the sole proprietorship to compute your taxable sole proprietor earnings. Your net earnings are then transferred to your 1040 form and reported with your other personal income, such as earnings from other employment, alimony payments you receive and interest income, to name just a few.
Read More: Why Is a Sole Proprietor Not Entitled to a Tax Deduction for Salary Payments to Himself?
Hobby Tax Implications
When your activity is a hobby, the IRS doesn’t allow you to deduct every expense you incur that relates to it. You must always report the income you earn from a hobby, even if not earned intentionally, on your tax return. You can take deductions for the hobby expenses you incur, but the amount cannot be more than the hobby income you report. Moreover, you must elect to itemize deductions on Schedule A; otherwise, none of your hobby expenses are deductible.
Jeff Franco's professional writing career began in 2010. With expertise in federal taxation, law and accounting, he has published articles in various online publications. Franco holds a Master of Business Administration in accounting and a Master of Science in taxation from Fordham University. He also holds a Juris Doctor from Brooklyn Law School.