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The IRS Criteria for Distinguishing
Hobbies From Businesses

If you’re earning money from a side hustle—whether it’s selling handmade products, flipping items online, or offering services—you need to understand one critical tax question: Is it a business or just a hobby?

The answer can have a major impact on how much you pay in taxes. If you get it wrong, you could end up paying taxes on income you didn’t actually profit from. Let’s break it down step by step.

The Golden Rule: All Income Must Be Reported

No matter what you’re doing—full-time business or weekend side hustle—the IRS requires you to report all income.

Even small amounts from casual sales or side projects must be included on your tax return.

The Big Difference: Deductions

Here’s where things get serious.

  • If it’s a business: You can deduct ordinary and necessary expenses
  • If it’s a hobby: You get zero deductions

That means if you earn $5,000 but spend $4,000 on supplies:

  • As a business → you’re taxed on $1,000 profit
  • As a hobby → you’re taxed on the full $5,000

This is why classification matters so much.

Why Hobby Expenses Are No Longer Deductible

In the past, hobby expenses could be partially deducted. However, the Tax Cuts and Jobs Act eliminated those deductions.

Recent tax law changes have now made that rule permanent—meaning hobby income is fully taxable with no offsets.

How the IRS Determines Business vs. Hobby

The IRS doesn’t just take your word for it. They look at several key factors to determine your intent.

1. Businesslike Operations

Do you treat your activity like a real business?

  • Separate bank account
  • Organized bookkeeping
  • Clear records of income and expenses

If your finances are mixed with personal spending, it raises red flags.

2. Time and Effort

Are you actively trying to make a profit?

The more time and energy you invest into growing the activity, the more it looks like a business.

3. Financial Dependence

Do you rely on this income?

If your side hustle helps pay your bills, it supports the argument that it’s a business—not just a hobby.

4. Profit History

The IRS also looks at whether you’ve made a profit over time.

Consistent losses may suggest a hobby—but not always. New businesses often take time to become profitable, and that can still qualify as a legitimate business.

Example Scenario

Let’s say Maria sells handmade candles online.

She earns $6,000 in sales but spends $4,500 on materials, packaging, and marketing.

  • If classified as a business → she’s taxed on $1,500
  • If classified as a hobby → she’s taxed on the full $6,000

That difference could cost her hundreds—or even thousands—in extra taxes.

Why This Matters

Take Kevin, who flips vintage clothing online. At first, he treated it casually and didn’t track expenses properly. When the IRS reviewed his activity, it leaned toward hobby classification—meaning he couldn’t deduct his costs.

After restructuring his operation with proper bookkeeping and business practices, he was able to establish himself as a legitimate business and significantly reduce his tax burden.

How to Protect Your Business Status

If you want the IRS to view your activity as a business, you need to act like one:

  • Keep detailed financial records
  • Separate personal and business finances
  • Create a plan to generate profit
  • Track all income and expenses
  • Stay consistent and organized

These steps strengthen your position and protect your deductions.

Conclusion

The line between a hobby and a business can be blurry—but the tax consequences are crystal clear.

If the IRS classifies your activity as a hobby, you lose valuable deductions and end up paying more in taxes than necessary.

If you’re earning income from a side hustle and want to make sure you’re set up correctly, contact Guerrero CPA at 210-490-7100. Our team will help you structure your activity properly, maintain clean records, and ensure you’re maximizing every tax advantage available.