Business vs Hobby Tax Deduction: How to Prove Your Side Gig Qualifies for Tax Breaks

Do you have a side gig apart from your main source of income?

From this sideline gig, do you claim tax losses on your personal tax return?

The IRS likes to claim that money-losing sideline activities are hobbies rather than businesses.

And you know what? You can’t deduct hobby losses on your form 1040. 

Below I will explain how to ensure that your sideline gig qualifies as business and therefore make your losses deductible.

Here’s the deal: if you can show a profit motive for your now-money-losing sideline gig, you can classify that activity as a business on your tax return and deduct your expenses.

Here are factors that prove profit-making intent:

What Does the IRS Say About Hobby vs. Business?

To deduct losses for a sideline gig, you need to prove to the IRS that you have a profit motive for the activity. In other words, you need to show that your activity isn't just a hobby, but a legitimate business operation. If you can establish this, you'll be able to classify your activity as a business on your tax return, which allows you to deduct your expenses.

Here are the key factors that demonstrate profit-making intent for your side business:

1. Maintain Accurate Accounting Records

Running your side gig like a business starts with keeping good records. Track all your income and expenses, and make a conscious effort to improve profitability. The IRS expects to see detailed accounting to demonstrate you're actively working toward making a profit.

2. Gain Expertise or Hire Experienced Individuals

A key indicator that your side gig is a business is if you have specialized knowledge or experience in the field. If you're not an expert, hiring experienced employees or contractors can show that you are serious about making your sideline gig a business.

3. Expect Business Assets to Appreciate

Consider the example of rental real estate. Even though there are often losses from rental properties, the IRS doesn’t consider it a hobby because the assets tend to appreciate in value over time. If your sideline gig involves assets that could appreciate, this strengthens the case that it’s a business.

4. Invest Significant Time in Your Activity

The IRS also considers the amount of time you spend on your sideline gig. If you consistently dedicate time and effort to the activity, it shows that you are committed to making it a successful business rather than just a hobby.

5. Demonstrate Past Success in Other Ventures

If you’ve had success with other businesses or ventures, it helps reinforce your side gig as a business. The IRS may look favorably on individuals who have demonstrated successful business practices in the past.

6. Evaluate Your Past Income and Losses

The IRS places more weight on intermittent large profits than on recurring small profits or constant losses. If your sideline gig has suffered some losses due to unusual circumstances (like an economic downturn or bad luck), the IRS may view these losses more favorably than constant, minimal profits that are common in hobby activities.

7. Consider Your Financial Situation

If you're able to absorb the losses from your side gig without significant impact on your overall financial stability, the IRS might view it as a hobby. On the other hand, if you're putting in effort to earn money and make a profit, that suggests you're running a business, not just engaging in a hobby.

8. Assess the Personal Pleasure Component

The IRS may consider certain activities—like breeding horses or painting—as hobbies because of the personal enjoyment they provide. However, if your sideline gig is focused on generating income (like building houses or restoring cars), it's more likely to be classified as a business.

Example: The For-Profit Auto Restoration Case

Let's look at a real-life example to see how the IRS applies these rules.

In 2016, a successful attorney was restoring Plymouth vehicles as a side gig. He managed all aspects of the business—advertising, sales, inventory, and more. He deducted his business-related expenses on his personal tax return, but the IRS audited him and rejected his deductions, claiming that it was a hobby rather than a business.

Here’s how the IRS’s rejection would have impacted him:

• $5,442 in accuracy-related penalties

• $6,802 in additional taxes

• $27,208 in past taxes owed

  
  

However, the attorney took the IRS to tax court, and the court ruled in his favor. The judge determined that he had a legitimate business, citing his knowledge of Plymouth cars, his advertising efforts, and his commitment to making a profit.

What Can We Learn from This Case?

• Hobby classification is detrimental for tax purposes.

• Business classification, even if there are financial losses, is typically more favorable and better for tax health.

If you’re unsure if your venture qualifies as a business or a hobby, the factors above can help you make the determination. For decades, the IRS has been pressing the business vs. hobby subject, and if you get audited, you want to make sure to have all your facts and documentation to prove that your business is a business and not a hobby.

If you ever need help with your taxes or accounting, please do not hesitate to contact us. Here is the list of our services.