Do You Own a Business or Have a Hobby?

If you're one of many citizens today operating a home-based business instead of working in a traditional office or factory setting, you may need to file a Schedule C, Profit or Loss From Business (Sole Proprietorship) with your income tax return.

According to the IRS, you're running a business if you regularly and with continuity engage in an activity intended to generate income or make a profit. If you engage in the activity only on occasion or you do it "just for fun" rather than to make money and profit, you have a hobby. If you're not sure whether you're operating a business or engaging in a hobby, the tax doctor can help.

Even if you don't have a business by the IRS definition, income you receive from your hobby must be reported to the IRS as "other income," and deductible expenses required to engage in the hobby cannot exceed the amount of money made.

Several Facts About Schedule C

If you're running a business organized as a sole proprietorship, you are required to account for your business income and expenses at tax time on a Schedule C. Profit or loss calculated on the Schedule C becomes a source of personal income in addition to any other W-2 or 1099-MISC earnings you may have had.

Schedule C provides the relevant accounting categories to record the cost of conducting business for the tax year. Business income less the cost of doing business determines either the profit or loss of the operation. If your business shows a loss in three out of five years, rolling, the IRS deems the activity a hobby. Deductions previously allowed may have to be reversed.

Self-Employment Tax Requirements

When you're in business for yourself and organized as a sole proprietorship, you are responsible for paying all the taxes related to your business, including state and Federal taxes as well as contributions to social security and Medicare funds. Schedule C also allows for identifying retirement plans offered by the proprietor.

The courts and the IRS consider profit motive as the underlying force defining a business. Generally speaking, any controversy over the business-hobby issue is settled by the practical aspects of the case. Is the activity capable of making a profit? Is the proprietor competent to operate and generate a profit from the business venture? Does the proprietor actively and materially participate in performing the activity? Is the proprietor's livelihood dependent on the profitability of the activity?

If you're not sure about the tax position of your small business, advice from the tax doctor can help.