You sold $2,400 of woodworking at craft fairs this year, and you spent $3,100 on lumber, tools, and booth fees. Whether that $700 gap helps you or hurts you at tax time depends entirely on one question: in the eyes of the IRS, are you running a business, or enjoying a hobby that happens to bring in money?

The label changes everything. A business reports income and expenses on Schedule C, deducts its costs, and can even use a loss to offset other income like wages. A hobby must report every dollar of income, but under current law gets to deduct essentially none of the expenses. Same lumber, same booth, very different tax bill. Here’s how the IRS draws the line, and how to stay on the side of it you intend.

The rule underneath: profit motive

The tax code’s test isn’t about size, or whether you have an LLC, or whether you enjoy the work. It’s whether you engage in the activity to make a profit. The IRS lays out nine factors it weighs, and no single one decides the question. In plain terms:

1. Do you run it like a business? Separate records, a business bank account, invoices, some form of bookkeeping.

2. Do your time and effort show you intend to make money? Regular hours and real work count; occasional puttering doesn’t.

3. Do you depend on the income? Money you need for living expenses looks like a business; pocket money looks like a hobby.

4. Are losses normal for the startup phase, or from things beyond your control? Early losses don’t kill a business claim if there’s a path out.

5. Do you change methods to improve profitability? Raising prices, cutting costs, dropping product lines that don’t sell.

6. Do you (or your advisers) know how to make this kind of activity profitable?

7. Have you made a profit doing something similar before?

8. What’s the history of income or loss, and are profits, when they happen, more than token?

9. Could you reasonably expect profit from asset appreciation, such as land or breeding stock gaining value?

And weighing against you: elements of personal pleasure or recreation. Enjoying the work doesn’t disqualify you, but it raises the bar for showing the other factors.

The three-out-of-five-years shortcut

There’s a presumption baked into the law: if an activity turns a profit in at least three of the last five tax years, the IRS generally presumes it’s carried on for profit (the window is two of seven years for activities involving horses). It works the other way too, informally: year after year of losses, deducted against a comfortable salary, is exactly the pattern that draws scrutiny. If you’re claiming losses, the nine factors above are your defense file. Keep it current.

Note what the presumption is not: it’s not a requirement that you be profitable to be a business. Plenty of legitimate businesses lose money for years, and the woodworker who lost $700 this year can still be a business if the records, the effort, and the plan point that way. The three-of-five test just decides who carries the burden of proof in an argument with the IRS.

Why hobby status stings now

It didn’t always. Before 2018, hobby expenses were at least partially deductible as miscellaneous itemized deductions. The 2017 tax law suspended those deductions, and the 2025 tax law made the change permanent, so today the rule is stark: hobby income is fully taxable, hobby expenses are essentially nondeductible. As the IRS puts it in its guidance for people who make money from a hobby, you report the income on Schedule 1 of Form 1040 as other income, and that’s the end of the math.

One more thing that surprises people: taxability doesn’t depend on paperwork. Whether or not a payment app or marketplace sends you a Form 1099-K, the income is reportable either way.

What business status costs you in exchange

Business treatment isn’t free money. Net profit from a Schedule C business is subject to self-employment tax, the 15.3 percent that covers Social Security and Medicare, on top of income tax, and profitable years may require quarterly estimated payments. You also take on real recordkeeping obligations, because every expense you deduct needs support. For a genuinely profitable side operation this trade is usually worth it, since deductions for supplies, mileage, equipment, and home-office use come with it, and the earnings build your Social Security record. Details live on the IRS’s Schedule C page.

Practical steps, whichever side you’re on

If you want business treatment to stick: open a separate bank account, keep a simple ledger, save receipts, write down your plan for reaching profitability, and actually adjust when something loses money. Those records map directly onto the nine factors, and they’re what an examiner asks for.

If it’s honestly a hobby, don’t force it. Report the income, skip the deductions, and enjoy the woodworking. Deducting years of losses from an activity you’d do anyway, with no records and no plan, is one of the older audit patterns in the book. The IRS’s own summary of the distinction is blunt about the deciding question: whether the activity is done to make a profit. Answer that honestly, document accordingly, and the label mostly takes care of itself.

This article was produced with AI assistance and reviewed by a human editor. Figures are linked to their primary sources; where a claim could not be verified from the public record, we say so.