In today's economy as the cost of living continues to increase many of us have taken what we once did for enjoyment and turned it into "side" jobs to earn a little extra cash.  Whether it's sewing, painting, building decks, web designing or babysitting we need to be careful on how we classify these activities.

Many taxpayers may be claiming business deductions when they actually have a hobby and the tax implications can be different for both.  What is a hobby?  Hobbies, also called not-for-profit activities, are those activities that are not pursued for profit.  What is a business?  Generally, your activity is considered a business if it is carried on with the reasonable expectation of earning a profit.  

Classifying your activity correctly is very important because if the Internal Revenue Service (IRS) classifies your business as a hobby your deductions could be disallowed or be reclassified as itemized deductions.  As a result, your tax liability to the IRS could increase.  If you are not sure whether you are running a business or simply enjoying a hobby, here are some of the factors the IRS considers:

1. Is the activity run in a business like manner?
2. Is the time and effort you put into the activity indicate an intention to make a profit?
3. Do you depend on income from the activity?
4. If there are loses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
5. Have you changed methods of operation to improve profitability?
6. Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
7. Have you made a profit in the past?
8. Does the activity make a profit in some years?
9. Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?

The IRS will generally assume a business is not a hobby if it showed a taxable profit in three of the previous five tax years.  However, if a business is not showing a profit it does not mean that the loss cannot be deducted, it just becomes more difficult to prove the profit motive.

If you are conducting a business you may deduct your ordinary and necessary business expenses against the business income.  If you have a hobby you may not use the expenses to offset the income however you may deduct the expenses as itemized deductions but be careful special rules and limits to deducting hobby expenses apply. So, is your activity a business or hobby?

Making the correct classification will have tax implications and you don't want to be one of the taxpayers who get additional scrutiny from the IRS.