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Why is the distinction between hobby and business important?

It may begin as a hobby. Perhaps a woodworking experiment or brewing gift set began as a fun pastime. But this new pastime has taken off. Perhaps you are spending more and more time on this hobby and you begin to wonder, could this be considered a business?

Why would I want to consider my hobby a business? There is one potential advantage to shifting a hobby into the world of business. Businesses can claim deductions: One of the benefits of having a business is the ability to claim losses for tax purposes. 

So how do I know if I have a business or a hobby? In the eyes of the Internal Revenue Service (IRS), a business generally must have profits that are greater than the claimed deductions for three of five consecutive tax years in order to qualify as a business. Without this, it may be considered a hobby — which would not qualify for the deduction.

There are some exceptions to this generality. The IRS will consider a number of factors if the above is not met. One factor involves a review of the manner the owner operates the business. A piece by CBS News digs into this issue, noting the IRS has looked into whether the taxpayer conducts himself or herself as a business person when working in the scrutinized activity when making its determination.

The agency will also look into the amount of time spent on the activity and the presence of income from other sources. If there is substantial income from another source, the IRS is more likely to consider the activity a hobby used to help make deductions from the primary source of income.

What if I falsely claimed my hobby as a business? Of course, an attempt to claim a hobby as a business can lead to a dispute with the IRS. This is true even if the mistake was unintentional. As a result, those who are wondering if their hobby is truly a business or who have recently received notification from the IRS of a tax dispute are wise to seek legal counsel. 

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