Reporting Hobby Income
And Losses
Many times parents will get involved with multi-level marketing companies or set
up a side business in order to generate additional income. This additional
income can be used to pay off debts or help pay for college expenses. If you
make money from an out-side activity, you will have to pay taxes on any profits
that are made. If you can consistently make money, or even if you do not, you
may run into a big surprise when tax-time rolls around.
If you do not set the out-side business up appropriately, the IRS could classify
your activity as a Hobby and not a business. Hobby income and losses are not
treated the same as business income and losses. The way the IRS treats hobby
income and losses is one of the worst tax laws on the books.
Normally during the first few years of engaging in a new enterprise, little money
or profits are made. Therefore, the losses from the activity can be used as a tax
deduction. However, losses from a hobby compared to a business are treated
differently. The first thing the IRS will look at is to determine whether your activity
is a hobby or business. If you have not set up your out-side activity the right way,
there is a good chance the IRS will determine you are earning additional money
under the Hobby rules, not as a real business.
If the IRS deems your out-side activity is a hobby and not a real business, you
can only deduct hobby expenses to offset your hobby income, but no more. If
your out-side activity was deemed as a real business, the IRS will let you deduct
business expenses against any business income and if your business deduction
is more than your business income, you can use the additional losses to offset
other taxable income.
The bad news does not stop here. If you have hobby income, you must report
hobby income as "other income" on your 1040 return, regardless of any
deductible hobby expenses. For example, if you make $3,000 from your hobby
activity and had $4,000 in hobby expenses, you still must include the total hobby
income on the front page of IRS form 1040, as other income.
On the other hand, If you earned $3,000 in a real business and completed IRS
Schedule C (sole-proprietor), you would claim the income on Schedule C not on
the front of IRS Form 1040 as other income. If you had $4,000 of business
expenses, you would include these expenses on Schedule C as well and
subtract these expenses from the gross income of the business. This would
show a business loss of $1,000. This loss would then flow over to the front of
your IRS Form 1040 (as a business loss) and would be used to reduce any other
taxable income i.e.., wages, interest, capital gains, rental income, etc. In other
words if you had $60,000 of taxable income, the $1,000 of business losses would
reduce your taxable income down to $59,000, ($60,000 - $1,000 = $59,000).
Hobby losses are treated differently than business losses. Not only do you have
to claim the hobby income as other income on IRS Form 1040, you can ONLY
deduct your hobby losses if you itemize your deduction on IRS Schedule A.
Itemized deduction are things like home mortgage interest and taxes, charitable
contributions, State income taxes paid, i.e.
If you can itemize your deductions, you would deduct your hobby losses as a
Miscellaneous Itemized Deduction. Under IRS rules, miscellaneous itemized
deductions are limited. In order to deduct hobby losses as a miscellaneous
itemized deduction, the losses must be more than 2% of your adjusted gross
income.
For example, if your adjusted gross income was $83,000 (which includes your
$3,000 of hobby income), you could only deduct $2,340 of hobby losses, not the
full $4,000,($83,000 X 2% = $1,660 - $4,000 hobby losses = $2,340 deduction).
Under this example, even though you DID NOT make a profit ($3,000 of income
minus $4,000 of losses or expenses), you will have to pay taxes on $660 of your
hobby income, ($3,000 - $2,340 losses = $660 taxable income.)
If you do not have enough itemized deduction to complete IRS Schedule A. You
CANNOT deduct hobby losses and must pay taxes on all of your hobby income.
Earning money as a hobby does have a benefit over earning money under a
business structure. The benefit is, earnings from a hobby is NOT subject to SelfEmployment Taxes. Self-Employment taxes is the same as Social Security
Taxes paid by W-2 earners.
If you run a hobby activity collect stamps, coins, etc., for recreation and pleasure
and you sell any of the hobby collection items, your gain or profit is taxable as a
capital gain on your tax return, NOT as other income. However, if you sell items
from your hobby collection at a loss, you CANNOT deduct a net loss on your tax
return.
For more information about deducting hobby expenses, check out IRS
Publication 535.
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