Determining whether a taxpayer's side hustle qualifies as a business and not just a hobby is an important distinction when it comes to tax rules, The Wall Street Journal reported.

A business operator can deduct ordinary and necessary business expenses against royalties and other income. Hobbyists, by contrast, are subject to a temporary provision in the 2017 Tax Cuts and Jobs Act (TCJA) that essentially eliminated deductions for expenses through 2025.

The IRS lists 11 factors to determine whether a taxpayer's activity is a business or hobby. They are whether:

• The taxpayer carries out the activity in a businesslike manner and maintains complete and accurate books and records.
• The taxpayer puts time and effort into the activity to show they intend to make it profitable.
• The taxpayer depends on income from the activity for their livelihood.
• The taxpayer has personal motives for carrying out the activity, such as general enjoyment or relaxation.
• The taxpayer has enough income from other sources to fund the activity.
• Losses are due to circumstances beyond the taxpayer's control or are normal for the startup phase of their type of business.
• There is a change to methods of operation to improve profitability.
• The taxpayer and their adviser have the knowledge needed to carry out the activity as a successful business.
• The taxpayer was successful in making a profit in similar activities in the past.
• The activity makes a profit in some years and, if so, how much profit it makes.
• The taxpayer can expect to make a future profit from the appreciation of the assets used in the activity.

In audits, the IRS decides what factors will weigh more heavily, depending on the facts and circumstances of each case, said Carol Topp, a CPA and author of a book on business and tax advice for writers, in an interview with the Journal.

In an example involving a retired lawyer turned budding novelist, Topp told the Journal that, in order to deduct the cost of researching and writing, the novelist  would need to be able to show that his efforts qualify as a business and not just a hobby. He will owe income taxes on sales either way, but the distinction matters, she said. Even if the novelists earns only a small amount from book sales, any business loss can be used to offset other income, such as wage or pension income, significantly reducing his tax bill. 

The IRS will also consider whether a taxpayer has the requisite skills and knowledge to do the business in a profitable manner. In the same example, the novelist took a $1,000 creative-writing workshop focused on romance novels through Stanford University’s continuing-studies program. That would help him to make that argument that he has these requisite skills and knowledge, said Jordan Rippy, a CPA and an associate professor at Johns Hopkins Carey Business School, in an interview with the Journal.

Taxpayers with small businesses will typically report income as sole proprietors. They must report the income, and any deductions related to the business, on Schedule C (profit or loss from business) of their individual tax return. Taxpayers with business income above a nominal amount also have to pay in self-employment taxes. Hobbyists do not.

Someone who has little or no income and tens of thousands of dollars of deductions can attract the attention of the IRS, but it doesn’t rule out that person's eligibility to deduct expenses, said Rippy. Turning a profit in three of the last five years, including the current year for which one is filing taxes, presumes that the business is being done for profit and the business-deduction rules apply, he said, but having a streak of losses doesn’t necessarily mean that the taxpayer is a hobbyist. The IRS will consider the issue on a case-by-case basis.

For taxpayers in the writing business, copyright-registration fees and advertising expenses count as legitimate deductions, Rippy said, as does the cost of a writing workshop. Deducting for travel expenses can be trickier; the taxpayer will need to keep track of the date and purpose of each expense.

One common mistake is using the tax break to justify spending money, Topp said. A taxpayer typically cannot deduct the mileage to drive to a local coffee shop to write, the cost of the coffee itself or the cost of meals in one’s home area. Those are personal, nondeductible expenses.