How to tell the difference and what it means for your taxes

Deciding whether income is hobby income or business income affects three main things: where you report it on your tax return, whether you owe self‑employment tax, and what expenses you can deduct. In my practice advising small business owners and side hustlers, a clear, documented profit motive and businesslike recordkeeping are the most common factors that move an activity from “hobby” to “business.”

This guide covers the IRS tests, practical recordkeeping steps, reporting workflows, and sample scenarios so you can classify income correctly and reduce audit risk.

Sources: IRS “Hobby or Business” guidance and Schedule C Instructions (irs.gov) and Social Security Administration rules for the self‑employment tax base.

The IRS framework: facts and circumstances

The IRS does not use a single bright‑line rule; instead it examines the taxpayer’s intent and the way the activity is carried out. A commonly referenced presumption: if an activity shows a profit in at least three of five consecutive years, the IRS will presume it is carried on for profit (two of five years for activities involving horses). However, this is only a presumption—not an absolute rule. The IRS looks at a variety of factors (often called the nine factors) including:

  • Whether you carry on the activity in a businesslike manner (bookkeeping, marketing, separate bank accounts).
  • Your time and effort to pursue profit.
  • Dependence on income from the activity for your livelihood.
  • History of income or losses from the activity.
  • Amount of occasional profits relative to losses.
  • Your experience, education, and expertise related to the activity.
  • Whether losses were due to circumstances beyond your control or are normal in start‑up phases.
  • Your success in similar activities.
  • Evidence of personal pleasure or recreation from the activity (strong personal enjoyment points toward a hobby).

(See IRS guidance: “Hobby or Business” at https://www.irs.gov/businesses/small-businesses-self-employed/hobby-or-business.)

Practical differences in reporting

Hobby income

  • Where to report: Report income from a hobby on Form 1040, Schedule 1, “Other income.” You must include the gross proceeds from sales or services. For 2025 and prior tax years under the Tax Cuts and Jobs Act, hobby expenses are generally not deductible — the suspension of miscellaneous itemized deductions (tax years 2018–2025) prevents claiming hobby expenses as an itemized deduction. Confirm current law each year at irs.gov.
  • Self‑employment tax: Hobby income is not subject to self‑employment tax because the activity is not a trade or business.
  • Net loss: You generally cannot claim a net loss from hobby activities against other income.

Business income

  • Where to report: Report business income and expenses on Schedule C (Form 1040). Net profit from Schedule C is subject to both income tax and self‑employment tax.
  • Self‑employment tax: You owe self‑employment tax (Social Security and Medicare) on net earnings if your net earnings are $400 or more for the year; report it on Schedule SE and the amount is used to calculate Social Security credits and Medicare. Half of the self‑employment tax is deductible as an adjustment to income on Form 1040.
  • Deductions: Businesses can deduct ordinary and necessary business expenses (home office rules, supplies, cost of goods sold, depreciation, business mileage, health insurance for self‑employed, retirement plan contributions, etc.), subject to normal tax rules.
  • Estimated taxes: If you expect to owe tax when filing, you likely must make quarterly estimated tax payments (Form 1040-ES) to avoid penalties.

Refer to the Schedule C information page for details: https://www.irs.gov/forms-pubs/about-schedule-c.

What changed with the Tax Cuts and Jobs Act

The Tax Cuts and Jobs Act (TCJA) suspended miscellaneous itemized deductions subject to the 2% floor for tax years 2018 through 2025. That suspension means most hobby‑related expenses that used to be deductible as miscellaneous itemized deductions are not deductible for those years. The income must still be reported. Check irs.gov each tax year for changes after 2025.

Step‑by‑step: How to report in common scenarios

Scenario A — Occasional sales from a hobby

  1. Add gross receipts from sales (e.g., online marketplaces, craft fairs) to your Form 1040, Schedule 1, line for “Other income.”
  2. Keep records of sales receipts and cost basis for items sold (purchase price, materials) to show accurate gross income.
  3. Do not claim hobby expenses on Schedule A (most hobby expenses are not deductible under current law).

Scenario B — Side hustle becoming a business

  1. Document the change in intent: business plan, marketing, separate accounts, consistent hours worked, formal pricing strategy.
  2. Start tracking income and expenses in a business ledger or accounting software. Open a separate bank account for business deposits and expenditures.
  3. Report income and ordinary and necessary expenses on Schedule C beginning with the tax year after you start operating for profit (or sooner if profit motive is already present).
  4. If net earnings from self‑employment are $400 or more, file Schedule SE to calculate self‑employment tax and consider making quarterly estimated payments.

Scenario C — Freelance or consulting work

Treat this as business income if you perform services for pay with profit motive. Report on Schedule C. Keep invoices, contracts, and time records to substantiate business status.

Recordkeeping checklist (what I tell clients)

  • Separate bank account and, if appropriate, a business credit card.
  • Accounting records (spreadsheet or bookkeeping software) showing income and expense categories.
  • Receipts, invoices, contracts, and proof of advertising/marketing costs.
  • Time logs if your labor is a significant factor in showing businesslike activity.
  • Evidence of improvements or investments (invoices for equipment, depreciation schedules).
  • Copies of relevant tax returns and supporting schedules.

These records make the difference if the IRS questions whether the activity is a business.

Examples that frequently arise in practice

  • Artist who sells occasional prints on Etsy: If sales are sporadic, social media is limited, and the activity is mainly for enjoyment, treat income as hobby income and report on Schedule 1. If the artist invests in a website, consistent advertising, multiple wholesale accounts, and demonstrates profit intent, switch to Schedule C.

  • Baker selling at farmers markets: Selling one‑off items to friends is likely a hobby. Running inventory, a separate bakery space, consistent pricing, and state sales tax registration point to a business.

  • Side consultant with a W‑2 job: Most paid consulting is business income if you invoice customers and seek to grow the client base—even as a part‑time business. Report on Schedule C and plan for self‑employment tax.

Common mistakes and how to avoid them

  • Treating every side sale as tax‑free. All income is taxable and must be reported.
  • Failing to document a change from hobby to business. Keep contemporaneous evidence (website launch date, advertising invoices, legal registrations).
  • Ignoring self‑employment tax when you have a Schedule C profit above the threshold. Use Schedule SE and estimate taxes quarterly if needed.
  • Throwing away receipts. Good records substantiate deductions and profit motive.

For practical detail on business reporting and common errors, see our page on Schedule C (Profit or Loss from Business).

When to get professional help

If you have significant income from a side activity, uncertain profit history, or a complex mix of inventory and services, consult a tax professional or CPA. In my experience, clients who consult early save time and reduce audit risk—especially when they plan to convert a hobby into a business.

Useful related reading on FinHelp:

Key takeaways

  • Classify activities by intent and businesslike behavior; the IRS applies a facts‑and‑circumstances test and a 3‑of‑5 profit presumption.
  • Hobby income is reported on Form 1040, Schedule 1; business income is reported on Schedule C and may be subject to self‑employment tax.
  • Under the TCJA (through 2025), most hobby expenses are not deductible. Businesses can deduct ordinary and necessary expenses.
  • Keep clear records and document any shift from hobby to business.

Professional disclaimer: This article is educational and not a substitute for personalized tax advice. For decisions that affect your taxes, consult a qualified tax professional or CPA and review current IRS guidance at https://www.irs.gov.

Authoritative sources and further reading

If you want, I can provide a one‑page printable checklist you can use to track the records the IRS is likely to request.