💯 💯 💯 "So the IRS states that your hobby turns into a business, when you start trying to earn money. a legitimate business has the primary purpose of income or profit."
EP 24: At what point does a hobby become a business? Is it when you get the first check? Is it when you get your first client? Your first repeat client? What does the IRS say about this? Does it even matter? In this episode, I will leave you with 9 questions to ask yourself to determine whether your ventures can be categorized as a legitimate business or a fun hobby.
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Michael Der 0:02
You're listening to Artrepreneurs, a podcast that inspires photographers and visual artists to live their best creative lives. My name is Michael Der and I am a full time photographer with nearly 10 years of experience in the freelancing world. And I'm sitting down with an amazing community of visual artists to talk about process, business, and the lessons that have helped them grow. So let's get to it. Artrepreneurs starts right now.
All right, what is up everybody? Welcome to Episode 24 of Artrepreneurs. Thank you so much for joining us today. As with many of the episodes on this channel, how I choose which topics to highlight typically stems from my own personal journey into self employment. So I frequently asked myself, What do I wish I knew when I first started out? So one of the most core basic questions I had at that time was, at what point do I officially become a business?
And at that time, I was working a full time sales job dabbling, with photography on the side, receiving very, very few gigs, here and there. So I certainly wasn't referring to my photography as a business at that time. But I didn't really know whether that was an accurate thing to do or not. And I wanted to know what that process entailed? Did I have to earn a certain amount of money to be called the business? Did they have to register with the state? Did I have to create a legal entity like an LLC or an S corp? What were those things? Anyways, all of these questions baffled me. And I remember taking a photography workshop really early on, and the person seated next to me asked, so do you have an actual photography business? And I had no idea what she meant by that question, and I certainly didn't know how to answer it. So if you are interested in figuring this part out as well, then you're in the right place. Today, I'm gonna identify how the IRS defines a business versus a hobby, and hopefully inspire you to think about whether it makes sense for you to take your passion to that next level.
Now, before we go any further for my dear friends and fellow colleagues living outside of the United States, I must apologize, I am more than likely unfamiliar with what your tax laws may or may not stipulate. So my hope for you is that this episode simply inspires you to do some of your own investigative research on the business requirements in your own home country. And whether or not it has those similar benefits. I also must state that I am no financial advisor or tax professional. So the definitions and the data that I will be providing today should be seen solely as educational and informational.
Okay, with that out of the way, let's first talk about what a hobby is. And let's assume you have a full time job and you're really passionate about another interest on the side, maybe it's photography, maybe it's graphic design, or retouching or doing hair and makeup. What would define this as a hobby is if you don't generate income from it. Now, you may take it very seriously, you may put a lot of hours into that craft, you may even spend a lot of money on it. But in the eyes of the revenue service of the US federal government, you are a hobbyist if there is no intent to make a profit or financial gain. So simple enough, right. But when does that definition shift?
this is where it gets a little bit more interpretive. So the IRS states that your hobby turns into a business, when you start trying to earn money. a legitimate business has the primary purpose of income or profit. Okay, so the key word in that statement to me is purpose. If your purpose is to generate income and profit, then you have taken the first steps in presenting yourself as a legitimate business. Now the IRS does clarify, you do not need to make a profit to be operating as a trade or a business. But you do need to have a motive for profit. So it is very much defined by the evidence that you have that can support the intention of profitability. And if that seems overly simplified and not really clear at defining what your situation is, just hang on. The IRS does have a list of nine factors to be used in determining whether an activity is a legitimate business or a hobby. So I'm going to be listing these factors in the form of nine questions to ask yourself, and if you answer yes to the majority of them, chances are you have sufficient evidence of running a real business.
Number one, do you maintain complete and accurate books and records. Alright, so this will apply to a wide variety of business-related aspects that you can actually measure. It could be profits and losses, maintaining receipts of your expenses, tracking professional mileage, charting your cash flow, even setting up things like a business bank account or a business credit card, those actions will act as a barometer for how much a person conducts their activity in a business-like manner.
Number two, do you and your advisors have sufficient expertise? So the IRS basically looked to see if you the taxpayer or your advisors have sufficiently spent enough effort learning about your trade, particularly when relating to market research and how to make your business more profitable? Are you taking classes? Are you attending workshops? Are you seeking out reading material on not just your art, but marketing and finance and business? And if not, do you have a team of professionals like an accountant, an attorney or a business coach whom you rely on?
Number three, does the time and effort you put into the activity indicate you intend to make it profitable? So basically, what you're being asked is are you spending enough time and energy producing assets and marketing them to generate income? So if you're practicing your photography, for instance, are you also
Looking to pitch those images to new prospects and leads? Or at least publish them on your website?
Four. Do you depend on income from the activity for your livelihood? So this is pretty self-explanatory here. assess how much your survival depends on this venture. Is it 10%? Is it 60%? Is it 100%? How you answer this will impact your business standing.
Number five, are your losses a normal part of startup costs? Are they due to circumstances you can't control? So for this, if you answer yes to both, you're in totally fine position. Basically, losses are expected in the startup stage. And it's really not proof that you have no intent for profit, you're simply building your client base while paying off startup expenses like equipment and insurance. And on top of that losses due to unforeseen circumstances like drought, fire, theft, and most recently global pandemics. They are not proof that your venture is a hobby, those are circumstances outside of your control. And the stronger evidence of your intent for profit should be based on the number of years of trials along with the many other factors in this list.
Number six, have you been successful in making a profit in similar activities in the past. So this relates to the taxpayer's history of income and losses with respect to the activity. So for many of you, you may have absolutely no history and you're pursuing photography for the first time. For others. However, having engaged in similar activities in the past and made them profitable, that may be indicative that you are engaged in business for profit despite your current venture showing loss.
Number seven, are you currently making profit? Alright, so since a business is defined as an endeavor with the intention of earning a profit, if you're consistently earning profit, then as stated you are running a business, If, however, your number of profitable years are slim, or non-existent at all, tax courts might actually see you as a hobby instead.
Number eight, can you expect the assets used in the activity to appreciate in value, so when this factor in mostly applies to land and real estate, which in photography terms, I can certainly envision owning a studio as a potentially appreciable asset, your business ownership as well could go up in value. But for the most part, my gut feeling is that's predicated on having a systems-based business that you could eventually sell. So if you own a photography business that can exist without you, such as somebody who runs a photography event company, then that would certainly apply. But you already know that you run a business. The majority of photography businesses, though, are individual creatives. And so this factor may be one of the few areas you respond no to.
Number nine, do you have personal motives for carrying out the activity? Okay, so this is a another gray area here, there's certainly no rule that states that you can't love your job. And depending on your personal code, some may say that it's a prerequisite. But that being said, work is still working. So if the endeavor is seen as too much fun or too extracurricular, a tax court may view it as a recreational hobby moreso than a business.
So I know that was a lot to consider there. But keep in mind, no one factor alone will determine your legitimacy as a business. And you don't have to answer yes to every single one of them to be considered one. But look at the totality of this list and consider all the factors in determining whether you really are in business to make profit. It's now that you have this information. The question comes down to why is any of this important? Is it more beneficial to be operating as a hobby, or as a business?
Well, if you keep your passion as a hobby, the benefit is you don't have to learn nearly as much about running a business, you do pay less than fees, and you don't have the added pressure of supporting your whole livelihood on whether you can sell your art that has the ability to take the joy out of a lot of practices. On the flip side, however, I could argue that learning how to run a business is something everyone should experience. It may be a lot more work, but it challenges you in ways that you never thought possible. I was a lifelong D student in high school and college. I mean, it is amazing that I graduated at any level. But the skill sets I've developed in business and finance and among other things. While they're still terrible compared to those who are more educated, they have grown substantially and I now have more confidence in my art as a result. And additionally, hobbies can't deduct losses from its activities. So if I didn't run a business, all of my equipment and software upgrades my website hosting my liability insurance, educational expenses, and all my marketing supplies, they could not be deducted. So the biggest advantage of running a business versus a hobby is that you can deduct losses against your income.
Now there is a lot more to go into on deductions, but I'm going to leave that for another day. That's not really the focus of this episode. If you are working as a part time creative and just want to know whether you qualify as a business or if your art is a hobby. Just remember that hobbies have no intent to generate profit businesses However, they do act with the intent to generate profit and your ability to provide evidence of habitual business practices is really going to help that case. Now if you do fit the qualifications of a business there are a couple formalities I want to let you know Firstly, you don't have to register or file any paperwork with the federal government to form a sole proprietorship which is what most photographers usually start out as if you go into business without setting up another business structure like an L
LLC or an S corp, then you are automatically considered a sole proprietor if you're the sole owner, the second formalities that you will need to obtain and pay for certain business licenses or permits to operate your business in any particular state, which may vary on the location but that's mostly it as a sole proprietor.
So I hope this episode gives you food for thought, everybody I know many of you already operate as self-employed creatives, and you don't really need any questions answered on if you are a legitimate business or not. But I did want to include those creatives who are either on the fence or just getting started in their careers. And if you are still unsure of your next step, and you need further clarification or guidance, consulting a tax professional should be your first move in starting your entrepreneurial or freelancing journey. And as I bring this episode to a close, I want to thank you all so much for tuning in and supporting this show. Artrepreneurs season one rolls on each Friday morning with brand new content. This is Michael Der signing off for now. Take care of yourself, everybody and have a great week.
Hey everybody, this is Michael Der thank you so much for making it all the way to the end of the episode. I hope you'll follow tag and engage with us on our Instagram account, @Artrepreneurspod. We've also launched our website Artrepreneurspod.com. It is the central hub where you can sign up for our newsletter, read our blog posts, send us voicemails, and even access discounts from our amazing affiliates. It's also the perfect spot to shout out entrepreneurs with what would be an immensely appreciated five star rating and review. And if you're feeling extra generous, you can even make a small donation that's really going to help accelerate the growth of this podcast. But no matter what you do, folks, I just want to say thank you so much for supporting the program. There are a lot of great photography podcasts out there and I'm just grateful to have gained your trust even for a moment. Take care everyone. See you next week.
Transcribed by https://otter.ai