Is Your Hobby Really a Business? Even if you think of your new pastime as a hobby, the IRS and your city and state tax authorities might disagree. Find out if there's more to your "hobby" than meets the eye.

A reader sent in the following question to me recently in regards to selling on eBay:

"Earlier this year I started selling stuff on eBay, mainly to clean out my attic. I ran out of attic stuff a while back, so I've started selling stuff for some of my friends and relatives. So far I've made about $50,000 after expenses and splitting the proceeds with the people who give me stuff to sell. I don't really look at this as a business, but I'm being told that I have to pay taxes on what I'm making. Is that right?"

Let me get this straight: You've made $50,000 in eight months and you're not sure if you have a business? Are you kidding?

A lot of people are surprised to find out that their cherished hobbies have somehow "morphed" into real businesses overnight without their knowledge. Your good-faith belief that what you're doing is "only a hobby" doesn't count for much, however, when it comes to the IRS and your state and local tax authorities. Under current law, if you're making even as much as $1 doing anything, the tax authorities don't care if it's a hobby or a business--they want their money. They'll view you as being self-employed, you'll have to report your earnings as income, and you'll have to pay taxes on that income.

"Gross income," as the IRS defines it, includes income "from whatever source derived." Let's say you're a coin collector. You sold two coins on eBay last year just to get them out of your collection, and you made $100 profit doing so. You should report the $100 as income on your tax return this year.

The "business vs. hobby" distinction truly comes into play when you lose money. So, in my example above, if you lost $100 when you sold the two coins on eBay, the IRS wouldn't let you deduct the $100 against your income from other sources, such as your day job. You can only deduct "hobby losses" against gains from the same hobby. So if this year you sell five coins on eBay, making a $200 profit on two of the coins and a $200 loss on the other three, you can "net" the loss against the profit and report zero income from your hobby.

A professional coin dealer doesn't have to worry about this because he or she is clearly engaged in a business. How do you tell the difference, especially when the business involves buying and selling stuff, something that many people do as a hobby--such as selling coins or antiques on eBay; breeding cats, dogs or other animals; making arts and crafts for sale at craft shows; publishing a newsletter; participating in various kinds of home party sales where your main objective is to get discounts on the products; and other activities where your primary objective is personal satisfaction rather than economic gain.

Under a long-standing IRS rule, you're considered a "business" if you made a profit in three of the past five years, including the current year. But what if you are just starting out and are likely to lose money this year?

Don't lose hope. You may still be considered a "business" for tax purposes if you can prove to the IRS that you're taking your activities seriously and are treating them as a business with the primary goal of making a profit . . . eventually.

So what sorts of things do you need to do? At a minimum, you should have a name for your business, some stationery, invoices, a separate bank account, separate books and records, a place in your home that's used only for this business activity, and some records to show that you're spending some time working on this activity on a regular basis. For example, if you're a coin collector turned coin dealer, you should keep thorough accounts and records, advertise in hobby publications, attend coin shows regularly in your area, and consider forming a corporation or limited liability company to run the business.

You should also consider preparing a formal business plan showing your projected income and expenses over a five- or ten-year period--with some profit at the end of that period. It would also help if you could show that you're actively studying and learning how to be financially successful in your business. Attending seminars, subscribing to trade magazines or newsletters, buying (and reading) books about the business and consulting with various professionals will also help.

You really need to talk to an accountant right away to determine your total tax liability, but based on your e-mail, I'm pretty sure that:

1. You'll have to pay federal, state and local income taxes on the full $50,000 in earnings from your business on eBay;
2. You'll have to pay self-employment taxes (roughly 15.3 percent) on everything you've earned from eBay sales over $400;
3. You'll have to pay these income and self-employment taxes in quarterly, estimated installments on April 15, June 15, September 15 and January 15 of each year; and
4. If you've received more than $600 in fees from any one of your friends or relatives this year, he or she may have to send you a Form 1099 next January.

But that's not all. It sounds as if you're taking consignments of stuff to sell on eBay. A growing number of states (mostly in the Midwest) are requiring eBay consignment sellers to obtain auctioneer licenses. If you live in one of these states, you'll have to pay a fee ranging from $200 to $500 and will also have to take an evening course in "auction practices" at your local community college before you can get the license.

Since it sounds like you've started a business, whether you knew it or not, and will have to pay taxes on your income, whether you like it or not, why not go the extra mile and set it up as a legal retail business? That way you can deduct your business expenses (most of them anyway), as well as certain of your household expenses if you claim the home office deduction. The steps involved are quite simple for a business like yours:

1. You'll have to obtain a federal Tax Identification Number (or Employer Identification Number) from the IRS. Go to www.irs.govand download Form SS-4, the application for a tax ID number.
2. You'll have to register for your state's sales, use and other business taxes--your accountant can help you with the necessary paperwork.
3. If you have a cute name for your business, you'll probably have to file a "trade name certificate" with your county or town clerk's office.
4. You'll have to file Schedule C form ("income or loss from a trade or business") with your Form 1040 each year.

Welcome to the wonderful world of self-employment! You've already passed the most difficult hurdle any new business faces--you're actually making money! The only businesses that are tax-free--other than charities--are businesses that don't make money. So set yourself up right, keep up the good work, and may you always regard your business as a "hobby" that's both fun and profitable.

Cliff Ennico is a syndicated columnist, author and host of the PBS television series MoneyHunt. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. Copyright 2005 Clifford R. Ennico. Distributed by Creators Syndicate Inc.