Which One Is Better? Hobby vs. Business For Tax Purposes

Pressed for time? Click to listen.

Most taxpayers are quick to classify their activity as a for-profit business instead of a hobby. Let's compare the two situations with a math example.



Product Recommendation: QuickBooks SE (up to 50% off), QuickBooks OnlineQuickBooks Payroll, QuickBooks Checks and Supplies (15% off + free shipping), Hiscox Business Insurance

[We may earn a commission or referral fee when you click on the links appearing in this post. Read full disclosure].

Assume you make $10 in gross sales, you have $3 in cost of goods sold (COGS), and $3 in other business expenses.

Hobby income

As a hobby, you may deduct the COGS to reduce the income you claim on your tax return. However, your costs cannot surpass the gross sales.

TIP: Check out our other article for details on the hobby vs. business test Hobby vs. Profit: Rules You Need To Know.

So, here's what the math breakdown looks like:

  $10 gross sales
- $  3 COGS
= $7 before-tax income

The IRS taxes hobby income based on your ordinary income tax rate. Let's assume you are in the 12% tax bracket.

   $7 profit
x 12% ordinary income tax rate
= $0.84 income tax

Your hobby activity triggered $0.84 tax.

Business income

As a for-profit business, you can deduct all your eligible business expenses which can surpass the income you made for the tax year. For this example, you can access the $3 COGS and $3 other business expenses.

  $10 gross sales
-   $3 COGS
-   $3 other business expenses
= $4 before-tax income

The IRS taxes business income two ways: self-employment (SE) tax and ordinary income tax. The SE tax is 15.3% of the business income after expenses, and we'll assume again you are in the 12% ordinary income tax bracket. 

TIP: You get a deduction for the employer portion of SE tax, which is 7.65%, so only 92.35% of your income (100% - 7.65% = 92.35%) is subject to tax. You also get a 20% discount for the qualified business income deduction or 199A.


$4 before-tax income

x 92.35% SE tax deduction
= $3.69 taxable income

Self Employment Tax:

$3.69
x 15.3%
= $0.56 self-employment tax

Ordinary Income Tax 

$3.69
- $0.74 QBI deduction ($3.69 * 20% discount)
$2.95 after QBI income
x 12% ordinary income tax rate
= $0.35 ordinary income tax

Your business activity triggered $0.56 SE tax and $0.35 of ordinary income tax or $0.91 tax.

Hobby v. business income analysis

Based on the example, you pay less tax as a business instead of a hobby because of the 199A deduction. However, if the business does not qualify for the discount (or is no longer available), and it has no other business expenses, then the hobby method wins. Let's see why.

Hobby Tax = $0.84


Business Tax = $1.77 (with no QBI deduction)


 $10 gross sales

- $3 COGS
= $7 before-tax income


 $7 before-tax income
x 92.35% SE tax deduction
= $6.46 taxable income

Self-Employment Tax:
$6.46
x 15.3% SE tax rate
= $0.99 SE tax

Ordinary Income Tax:  
$6.46
x 12% ordinary income tax rate
= $0.78 ordinary tax

Here, the business activity results in more total tax — $0.99 SE tax plus $0.78 ordinary income tax ($1.77).

Conclusion

If you don't have a lot of business expenses on your federal tax return, and cannot access the QBI deduction, then you'll pay more tax as a business than a hobby. Even if you're unable to itemize expenses on Schedule A to claim the hobby expenses, and you paid tax on the gross sales ($10 12% ordinary income tax = $1.20), the hobby method still saves tax.

If the business has a lot of expenses, and it can access the QBI deduction, then the business method saves tax as compared to a hobby.


READ MORE: Hobby vs. Profit: Rules You Need To Know





DISCLAIMER: Please consult with your accountant, attorney, and financial advisor before implementing any information displayed on this website. DIY research does not replace the advice of a licensed professional who has thoroughly reviewed your file.