Need to Know Tax › Side income
Side income
Is it a business or a hobby?
How the IRS decides whether a side activity is a business, why hobby income is taxable while hobby expenses aren’t deductible, and the factors that tip the balance. The difference matters more than most people expect, and it is settled by records, not by what you call it.
If you sell crafts, raise horses, breed dogs, or do photography on the side, the IRS will want to know whether it is a business or a hobby. The difference matters more than most people expect. Business expenses are deductible, and a business loss can offset other income, such as wages. Hobby income is fully taxable, and hobby expenses are not deductible at all; the 2025 tax law made that permanent. An activity that loses money is where the IRS pays attention, because a loss that offsets wages is a real tax benefit, and that is the case it challenges.
| Business | Hobby | |
|---|---|---|
| Income taxable | Yes, net of expenses | Yes, gross |
| Expenses deductible | Yes | No |
| Loss offsets other income | Yes | No |
| Self-employment tax (15.3%) | Yes, on net profit over $400 | No |
| Reported on | Schedule C | Schedule 1, other income |
| Retirement plan and HSA contributions from the income | Yes (SEP, solo 401(k)) | No; not earned income |
| Earned income credit | Counts as earned income | Does not |
Worked example: $6,000 of pottery, both ways
A potter sells $6,000 of work at markets and online and spends $4,000 on clay, glazes, kiln time, booth fees and shipping. She is in the 22% bracket.
| As a business (Schedule C) | As a hobby (Schedule 1) | |
|---|---|---|
| Income reported | $6,000 | $6,000 |
| Expenses deducted | $4,000 | $0 |
| Taxable | $2,000 | $6,000 |
| Federal income tax at 22% | $440 | $1,320 |
| Self-employment tax (15.3% on 92.35% of profit, half deductible) | $283 | $0 |
| Colorado at 4.40% | $88 | $264 |
| Total tax | about $780 | about $1,580 |
Rounded. Business treatment costs less here even with self-employment tax, and it opens a SEP contribution and counts toward Social Security. In a year she spent $8,000 and sold $6,000, the business shows a $2,000 loss against her wages; the hobby still owes tax on $6,000. That loss year is the one the IRS looks at.
How the IRS decides
The question is whether you run the activity like a business and have a realistic expectation of profit. No single fact decides. Among the factors the IRS weighs: whether you keep separate records and a separate bank account; the time and expertise you put in, and whether you sought advice from people who know the trade; whether you changed how you operate when it was not making money, by raising prices, cutting costs or dropping a line that did not sell; whether you depend on the income; your history of profit or loss in this and similar activities; whether the assets are expected to appreciate; and how much of the appeal is personal enjoyment. An activity that is mostly recreation, with sales as a byproduct, is a hobby.
There is also a presumption that helps. An activity that shows a profit in three of five consecutive years is presumed to be a business, and the IRS has to prove otherwise. For horse breeding, training, showing and racing, it is two of seven years. Failing the presumption does not automatically make the activity a hobby; it just means the factors decide.
A few bad years
A few years of losses is not fatal. New businesses lose money, and farms, rentals and anything with heavy startup costs can lose for longer. What you should be able to show is a real plan for making money: a written plan, a budget, records that a banker would accept, and evidence that you changed course when the numbers said to. What hurts is a pattern of losses year after year, with no change in how the activity is run, especially when the activity is one people do for pleasure and the loss is conveniently sized against a salary.
Records that settle it
Keep the activity’s money separate from household money. Record every sale and every expense with a date and a purpose. Keep a log of hours and of business miles (72.5 cents for January through June 2026, 76 cents from July). Save the business plan, the price list, the ads and the notes from anyone you consulted. A spreadsheet is enough; a shoebox is not. The records that prove the activity is a business are the same ones that turn gross sales into the profit actually taxed, and the same ones that answer a 1099-K.
Behind the scenes
When a Schedule C shows a loss for the third year running, a preparer asks the questions the IRS would ask before signing. Is there a separate account? Where do the receipts live? What changed this year compared with last? The answers go in the file, not on the return. If the honest answer is that the activity is a hobby that happens to sell a few things, the preparer moves the income to Schedule 1, drops the expenses, and tells the client why the refund went down. A preparer who signs a fourth loss year without asking is signing something the IRS will ask about instead.
The Colorado side
Colorado follows the federal answer: net profit from Schedule C, or gross hobby income from Schedule 1, flows into Colorado income at 4.40%, and a business loss that offsets wages federally offsets them in Colorado too. A business selling goods to Colorado buyers directly, rather than through a marketplace that collects for it, generally needs a Colorado sales tax license, which is separate from income tax and applies whether or not the activity is profitable (verify). An owner of a pass-through business with large income has Colorado’s own addback of the 20% business deduction above $500,000 / $1,000,000 of AGI to consider; a side business never gets there.
What to bring your preparer
- A record of every sale for the year, and every 1099-K or 1099-NEC received
- Expenses by category with receipts: materials, fees, shipping, advertising, equipment, a mileage log
- Bank and card statements for the activity’s account, if it has one
- The last few years’ results, so the three-of-five presumption can be checked
- A written plan or budget, and a note of anything you changed this year to improve results
- An honest sense of how much of the activity is for pleasure
Questions people ask
I sold $1,500 of crafts at holiday markets. Do I have to report it?
Yes. All income is reportable. If it is a business, net profit over $400 also owes self-employment tax; if it is a hobby, the $1,500 goes on Schedule 1 with no deductions. Either way, keep the receipts.
Can I deduct hobby expenses up to the hobby income, like before 2018?
No. That deduction ended with 2017 and the 2025 law made its repeal permanent. Hobby income is taxed on the gross.
My photography business has lost money four years running. Is it a hobby now?
Not automatically, but the presumption is against you and the factors decide. If you can show a plan, separate records, changes you made to turn it around, and that it is not mainly recreation, it can still be a business. If none of that is true, it is a hobby, and the losses were never deductible.
Does a business have to make money every year?
No. Profit in three of five years creates a presumption in your favor; losses in startup years and bad years are normal. The question is intent and conduct, not any one year’s result.
If I call it a business, can I deduct my home studio?
A space used regularly and exclusively for the business qualifies for the home office deduction, at $5 per square foot up to 300 square feet or the actual cost share. The exclusive-use rule is the hard part for a spare bedroom.
Is there a way to keep the IRS from deciding too early?
Form 5213 asks the IRS to wait until the end of the fifth year (seventh for horses) before applying the presumption, so a startup can accumulate its profit years. The trade is that it keeps those early years open for audit longer, so it is filed rarely and only on advice.
Which activities get the closest look?
Horses and livestock, small farms and greenhouses, photography, art, music and writing, crafts and online selling, and guide services for hunting and fishing: activities people would do for pleasure anyway, with losses that happen to offset a salary. Selling your own used household goods for less than you paid is none of this; it is not hobby income at all, and no tax is owed, though it helps to keep a record of what the items cost.
A spreadsheet is enough; a shoebox is not
The records that prove the activity is a business are the same ones that turn gross sales into the profit actually taxed. A separate account, a log of every sale and expense, and a written plan settle the question before the IRS asks it.