Is Your Home Business Really a Business? — The IRS Hobby vs. Business Test (2025)
Many Americans start a side hustle or small home business, but the IRS does not automatically consider every money-making activity a “business.”
If the IRS believes your activity is a hobby—not a business—you could lose all deductions and face additional tax.
This guide explains how the IRS applies the Hobby vs. Business Test, what “profit motive” really means, and how to protect your deductions for the 2025–2026 filing seasons.
1️⃣ Why the IRS Cares — Tax Basics for Home Businesses
A legitimate home business can deduct ordinary and necessary expenses under IRC §162.
These deductions reduce:
- Income tax (10%–37% brackets in 2025)
- Self-employment tax (15.3%)
But if the IRS determines the activity is a hobby, no business deductions are allowed.
That’s why proving you operate “with intent to make a profit” is essential.
💡 Example
A freelance designer earns $30,000 and has $8,000 in expenses.
If treated as a real business, they pay tax on $22,000.
But if the IRS calls it a hobby, they lose the $8,000 deduction and owe tax on the full $30,000.
2️⃣ The Official IRS Hobby vs. Business Test
The IRS evaluates whether an activity is engaged in “for profit” by examining multiple factors (not just income).
Key indicators include:
- ✔️ You operate in a business-like manner
- ✔️ You maintain accurate books and records
- ✔️ You put time and effort into making the activity profitable
- ✔️ You depend on the income for your livelihood
- ✔️ Losses are due to circumstances beyond your control
- ✔️ You have a track record of making profits in similar activities
- ✔️ The activity shows improvement over time
No single factor determines the outcome—the IRS looks at the total picture.
3️⃣ Understanding the “Profit Motive” Requirement
The IRS presumes you are running a business—not a hobby—if you show a profit in at least:
3 out of 5 years (special rules apply for horses).
A profit doesn’t have to be huge; even a small net income counts.
What matters is demonstrating actions that show you “intend to make money.”
🧭 Profit Motive Indicators
• Keeping a separate business bank account
• Having contracts, invoices, or regular clients
• Advertising and marketing
• Updating your business plan
• Tracking expenses and revenue
4️⃣ Real-World Examples
💡 Example 1 — Real Business
A photographer earns inconsistent income but keeps proper books, invoices clients, updates pricing, and advertises locally.
Even with losses in some years, the IRS would likely treat this as a legitimate business.
💡 Example 2 — Likely Hobby
Someone sells handmade crafts occasionally, doesn’t track costs, has no separate account, and never attempts to increase sales.
Even if they earn some money, the IRS may classify this as a hobby.
5️⃣ How to Protect Your Status as a Real Business
✔️ Practical Tips
• Keep accurate books & receipts
• Maintain a separate bank account
• Document marketing efforts
• File Schedule C consistently
• Create an annual business plan
• Show progress toward profitability
The more your business resembles a real, organized enterprise, the easier it is to defend your deductions during an audit.
-
QuickBooks Online — Small Business Accounting & Bookkeeping
-
TurboTax Self-Employed — For Freelancers & Home-Business Tax Filing
*As an Amazon Associate, EA Tax Guide may earn from qualifying purchases.
- ① Is Your Home Business Really a Business?
- ② Do You Have a Profit Motive?
- ③ Can You Deduct Your Startup Costs?
- ④ Operating Expenses You Can Deduct
- ⑤ Section 179 & Bonus Depreciation
- ⑥ Home Office Deduction
- ⑦ The QBI 20% Deduction
- ⑧ Car & Local Travel Expenses
- ⑨ Out-of-Town Travel Rules
- ⑩ Inventory Rules
- ⑪ Employees vs. Contractors
- ⑫ Health Insurance & Medical Deductions
- ⑬ Retirement Plan Deductions
- ⑭ Additional Business Deductions
- ⑮ Crypto in Your Business
- ⑯ Recordkeeping & Accounting
- ⑰ Spouses in Business Together
- ⑱ How to Avoid an IRS Audit