Hobby or Business? How the IRS Decides What Your Side Hustle Is, and Why It Changes Your Tax Bill

If you sell what you make or charge for what you do, the IRS wants to know one thing: are you trying to make a profit? The answer decides which costs you can deduct.

What is the difference between a hobby and a business for taxes?

The difference is intent. The IRS says businesses operate to make a profit, while hobbies are for pleasure or recreation. Both kinds of income are taxable, but only a business can deduct its expenses against that income. No single factor decides it; the IRS looks at how you actually run the activity.

That one distinction has real money behind it. Take two people who both sell handmade jewelry at weekend craft fairs and online. They earn the same amount and spend the same amount. If one is treated as running a business and the other as having a hobby, they can end up with very different tax bills on identical numbers.

This guide is for anyone earning money on the side from something they enjoy: crafts, baking, photography, music lessons, reselling, dog breeding, woodworking. It walks through how the IRS draws the line, what each label costs you with worked examples, and a checklist of habits that show a profit motive. It explains how the rules work; it isn't tax advice for your situation, and tax law can change, so check irs.gov or a tax professional before you file.

Why the label changes your tax bill

If it's a business, you report income and expenses on Schedule C. Ordinary and necessary costs, such as materials, booth fees, platform fees, supplies and a share of equipment, reduce your profit. If you spend more than you earn, a business loss can generally offset other income, such as wages, subject to other tax limits. The IRS's hobby-versus-business fact sheet makes the flip side clear: without a profit motive, you can't use a loss from the activity to offset other income.

There is a trade-off. Business profit is subject to self-employment tax, the Social Security and Medicare tax that people who work for themselves pay. The IRS says the rate is 15.3%, and you must file Schedule SE if your net earnings from self-employment are $400 or more.

If it's a hobby, you still report the income. The Taxpayer Advocate Service says hobby income goes on Schedule 1 of Form 1040 (line 8j on recent versions of the form). And as noted above, a hobby loss can't offset your other income. Under current federal law, a hobby's other expenses generally aren't deductible: the 2017 tax law suspended the miscellaneous itemized deductions that hobby costs used to fall under, and the 2025 One Big Beautiful Bill Act made that permanent, CPA Practice Advisor reports.

One cost still counts for a hobby that sells goods. Tax educators, including the University of Illinois Tax School, explain that hobby gross income is your sales minus a reasonable, consistently figured cost of goods sold, meaning costs such as the materials in the items you actually sold. The same source notes that a profitable activity treated as a hobby may avoid self-employment tax.

A worked example: same numbers, two outcomes

Meet Dana, who makes beaded jewelry and sells it at craft fairs and through an online shop. In one year her numbers look like this:

• Sales: $6,000
• Cost of the materials in the pieces she sold: $2,000
• Other costs (booth fees, shop fees, display racks, tools, mileage to fairs): $5,000

Treated as a business: $6,000 minus $2,000 minus $5,000 equals a $1,000 loss. That loss can generally reduce her other taxable income, such as the wages from her day job. If her top federal bracket is 12%, the loss trims her federal income tax by about $120.

Treated as a hobby: her hobby gross income is $6,000 minus $2,000, or $4,000, reported on Schedule 1. The other $5,000 in costs can't be deducted. She pays income tax on $4,000 even though she lost $1,000 overall. At a 12% bracket, that is about $480 in federal income tax.

Same activity, same cash, roughly a $600 difference in federal income tax, before any state tax.

Now flip it. Suppose a later year goes well: $15,000 in sales, $3,000 in materials for items sold and $4,000 in other costs. As a business, Dana has an $8,000 profit. She owes income tax on it and self-employment tax on her net earnings from self-employment. As a hobby, she would report $12,000 of gross income and deduct none of the $4,000. Which outcome costs less depends on the numbers, but here is the key point: you don't get to pick the label that saves the most tax. The IRS decides based on how the activity is really run.

How the IRS decides: the nine factors

The rules live in Section 183 of the tax code and its regulation. The regulation lists nine factors and says "no one factor is determinative" and that the decision is made "by reference to objective standards." In plain English, here is what each one asks:

1. How you carry on the activity. Do you keep complete, accurate books and run it the way profitable businesses of the same kind are run?
2. Your expertise or your advisers'. Did you study the market or follow expert advice on pricing, costs and sales?
3. Time and effort. Do you put in steady, substantial work, especially on tasks that aren't fun?
4. Whether assets may grow in value. Could equipment or land used in the activity rise in value?
5. Your track record. Have you turned other ventures from losses into profits before?
6. History of income or losses. Losses in the early start-up years are normal. Losses that go on and on, with no change in approach, are a warning sign.
7. Occasional profits. Have you earned a profit in some years, and how big?
8. Your financial status. Do you rely on this income, or do the losses mostly lower the tax on a large salary?
9. Personal pleasure. Enjoying the work is fine, but if the activity is mainly recreation, that points toward a hobby.

The three-out-of-five-years rule

The tax code gives a helpful presumption. If an activity shows a profit in at least three of five consecutive years, it is presumed to be engaged in for profit unless the IRS shows otherwise. For activities that mainly involve breeding, training, showing or racing horses, the test is two out of seven years. Missing the presumption doesn't make an activity a hobby; it means the decision falls back on the nine factors.

If you are just starting out, there is an option to buy time. IRS Form 5213 lets you ask the IRS to postpone deciding whether the presumption applies until after your fifth year (seventh for horse activities). The form generally must be filed within three years after the due date of the return for the activity's first year, or within 60 days of an IRS notice proposing to disallow your deductions. The catch: filing it automatically extends the time the IRS has to assess tax tied to the activity for those years. Some tax professionals rarely recommend it and focus on good documentation instead, so it's worth discussing with a preparer first.

What happens when the IRS says it's a hobby

Courts take these cases seriously. In one Tax Court case (Schumacher, T.C. Memo. 2026-27), a couple ran a horse-breeding activity for about 20 years and lost more than $100,000 every year, including after building a $230,000 indoor riding arena. They kept notes rather than formal books and moved money between personal and activity accounts. Applying the nine factors, the court ruled it was not a business and disallowed all of the claimed losses, CPA Practice Advisor reported.

Most side hustles are far smaller, but the lessons scale down. Years of losses, loose records and mixed-up bank accounts are exactly the facts that hurt.

A checklist to show you're running a business

None of these steps guarantees business treatment, but each one is evidence that you are trying to make a profit:

1. Open a separate bank account for the activity and run every sale and expense through it. Our guide to separating business and personal finances covers the setup.
2. Keep real books. A spreadsheet or bookkeeping app that tracks every sale, cost and receipt beats a shoebox.
3. Write a short plan. One page with your prices, costs per item, sales channels and a target date for turning a profit.
4. Price for profit. Know what each item costs to make, including fees and your time. Our guide to selling handmade crafts online walks through fees and pricing.
5. Market it. A shop page, business cards, social posts or a simple website show you're seeking customers, not just sharing a pastime.
6. Change course when it isn't working. Raise prices, cut slow sellers or try new channels, and keep notes on what you changed and why.
7. Track your time. A simple log of hours spent making, selling and on admin supports the time-and-effort factor.
8. Learn the trade. Classes, industry groups or advice from people who run profitable shops count toward expertise.

Some people do all of this and still decide the activity is a hobby, and that's fine. The point is that the label should match the facts. Whichever it is, keep good records: the Taxpayer Advocate Service notes you may receive a Form 1099-K for money you receive from a hobby or a business. For the broader rules on estimated payments and deductions once you're a business, see our guide to side hustle taxes.