The US tax system is complex and often misunderstood. The purpose of this article is to describe how hobby activities are treated for income tax purposes by the Internal Revenue Service. However, before that question can be fully addressed, it's important to understand some fundamental tax concepts which will also be briefly discussed in this article.
Hobby Activities vs Business Activities
A hobby is something you do for fun or pleasure which is not intended to make a profit. A business, on the other hand, is engaged with the intention of making a profit. There is no fixed definition for what constitutes a hobby and there are many factors that need to be taken into account in determining whether an activity should be treated as a hobby or a business.
The IRS has identified several different factors which would cause an activity to be considered primarily as a business and not a hobby: (1) the manner in which you conduct your activities; (2) the time and effort that you put into it; (3) whether you depend on income from the activity – with the intention of making a profit.
If an activity makes money after expenses are paid then it's probably doing business even if one doesn't intend to be in business when they start out. The IRS suggests that if your activity makes a profit in at least three of the last five years (or, seven out of ten) then you probably have a business and not a hobby.
The IRS does allow for certain exceptions to the general rule. One such exception is called "the hobby loss rules." There is no black and white test for an activity to be considered a hobby, rather there are several factors that the IRS looks into when determining whether your activity is a business or just for fun.
A recent Tax Court case addressed this issue. In this case, Mr. Stidham was an attorney who had other hobbies on the side. The first part of his activities were private dances that he put on at nightclubs. The second part of his activities was the playing and trading of personal computer games. The Tax Court held that Mr. Stidham's dancing activity should be considered a hobby and not a business because it was not regular, continuous, and carried on in a businesslike manner.
The Tax Court concluded that Mr. Stidham's computer game activities were regular and recurring and not just for fun and therefore should be treated as a business activity.
In this case, the Tax Court used both subjective and objective factors to determine if Mr. Stidham's dancing activity was and substantial as required under the general rule for businesses, however, they also stated that whether his computer game activity should be considered for hobby treatment was not addressed because the record did not show sufficient facts about it. It's important to note that what will separate a hobby from a business is how much time and effort the taxpayer puts into the activity; this point is relevant when determining if your particular gaming activities meet the "regular, continuous, and carried on in a businesslike manner" test that the Tax Court used as a guideline for determining whether or not to treat your hobby as a business.
Income from Passive Activities
Another important tax rule is how passive activities are treated by the IRS. As with most tax rules, there are exceptions to the general rule, however, the general rule is that if you make money from a passive activity, the money will be taxed at ordinary income rates. The general rule found in section 469 of the Internal Revenue Code states that any income or loss from passive activities must be reported on Form 8810 and then carried over to page one of your tax return.
There are many types of passive activities, however, the most common one that individuals will encounter is a trade or business activity in which you did not materially participate. The guidelines set out by the IRS as to what constitutes material participation are as follows: (1) if you work 500 hours or more during the year in your trade or business; (2) you don't work 500 hours or more in any other trade or business; and (3) you don't work 500 hours or more for the company in a non-trade or business capacity.
In order to avoid this rule, many people who might otherwise try to claim that their gaming activities are passive activities will form an entity. By doing so, they can often claim that their business is separate from the other aspects of their lives.
Another way to avoid this rule is by having your activities classified as an "S" corporation or, if you are a sole proprietor, being liable for certain self-employment taxes.
