even if you charge $$ it's a hobby

No one can argue with the IRS!!! Thanks for the information!!

Those IRS questions go to the deductibility of expenses and whether you have a hobby or a business, but even if you have a hobby and not a business, hobby income is taxable.  And state licensing requirements, if any, still apply as to whether you can legally accept money for cakes.  

Edited by VanillaSky - 2/26/13 at 4:08pm

This thread is just downright amusing! K8Memphis, you're right on!

 

Note that if you itemize on your tax return and you meet the 2% floor, you can deduct some of your hobby expenses...For example, for simplicity's sake, say you gross $1,000 for the year (aggregate sales price of all cakes "sold") and you spent $3,000 on ingredients, pans, cookie cutters, storage boxes, decorating books, Craftsy classes, etc. you have to report the $1,000 as income. Now, say your AGI is $100,000. 2.5% would be 2,500. SO, you can deduct expenses in excess of that amount, which would be $3,000-$2,500=$500 deductible. BUT that's only if you itemize...all the people out there who simply take the standard deduction are out of luck!

 

Now, isn't that a hoot?!

 

I'm not offering any legal advice to anyone, but seriously ya'all, if you think less then 500 words copied and pasted from a tax website accurately sums up what is and is not a legal business and there is no other information required OR any other governing authorities that may have different rules and opinions, then we'd never need CPA's.  

 

I appreciate your original post, K8, but I fear you are beating a hornet's nest here.

As do health department and food laws.

I'm working on my master's in accounting with an emphasis in taxation, so I have studied this extensively (far more than I have wanted to!). K8 is right. I'm not here to say everyone baking cakes has a hobby issue on their hands, but it is true that more goes in to determining whether selling cakes is a "business" or "hobby" as defined by the IRS.

 

 

Again, a lot of different factors have to be considered. And different CPAs will interpret the law differently. What I posted earlier is based on my strict interpretation of the laws. There are a lot of court cases out there that deal with this topic precisely.

Edited by texascakebaker - 2/26/13 at 5:41pm

The IRS's definition of a business vs. a hobby is for a very specific purpose: to make sure most business deductions that offset other income are the result of for-profit activity and not personal activity (e.g. a hobby). It is in fact more beneficial for the IRS to consider you a business than a hobby, which is the opposite of every other food safety and licensing dept (where a business can mean required inspections and additional fees).

If you have a fully licensed and inspected bakery it still is possible to be considered a hobby by the IRS if you post losses year after year and do not work to improve profitability (this would not be a good thing). If you bake from home, do not have a license or comply with local food safety laws, and only sell food for friends and family as a "hobby" it is also possible to be considered a business by the IRS, which is actually to your benefit.

The issue most often discussed on this forum is one of microeconomics...if you are advertising products for sale to the general public (even if that advertisement is just a web site or FB page), you are running a business, and you have a duty to at least have a general idea what market values are and price accordingly. This has absolutely nothing to do with how the IRS allows you to apply deductions to offset other income.

If you don't want to run a business, take down your web site and business FB page, do not mention that you sell cakes outside of your circle of family and friends, and do not accept orders from people outside your circle.

I believe you are only allowed to deduct hobby expenses (subject to the 2% floor) up to your hobby income. So in your example, since your hobby grossed $1000, you would only be able to deduct $1000 in hobby expenses. However, if you had no other misc expenses under Schedule A you would not reach the 2% AGI floor (assuming $100K AGI) and would not be able to deduct any hobby expenses, which means you would owe income tax on all of your hobby income.

http://www.nolo.com/legal-encyclopedia/can-you-deduct-your-expenses-from-hobby.html

Now if you were a business in the eyes of the IRS, you would be able to deduct the entire $3K (assuming valid business expenses of course). Not only would you not have to pay tax on your $1K cake income, but $2K of income from other sources would be tax-free as well.

Jason, yes, I got the limitations a little mixed up in the previous post. I think I have it straight now. Somebody jump out there and correct me if it looks fishy!

 

Assuming your activity is a hobby, you can only deduct hobby losses to the extent of hobby income (i.e. no net hobby losses, which is the point of the provision). 

 

Essentially, there are three potential limitations to hobby loss deductions applied in the following order. Get ready...

 

Going back to the previous example and assuming it's a hobby...1,000 gross income on hobby cakes; 3,000 expenses on hobby cakes; 100,000 AGI

 

Test 1: The first number for "potentially deductible hobby losses" is the same amount of your gross income. That is, you cannot use an expense number larger than the gross sales number. So, 1000 of income; 1000 of expenses (Note: tossed by the wayside: 2,000 in expenses that will never see the light of deduction day...)

 

Test 2: I misspoke above...it is the 2% AGI test, not the 2.5% test. (Ignore the previous numbers as well ...my humble apologies. The numbers and order of applying the limitations were mixed up) ...So, since $1,000 of expenses fails to meets the 2% AGI test, none of the hobby losses are deductible. End Result: Report 1,000 as hobby income and zero expenses will offset...

 

Example Tweaked: 10,000 of hobby income, 10,000 of expenses. still 100,000 AGI. In test 2...10,000 of expenses exceeds the 2% floor, so 8,000 would be a miscellaneous itemized deduction....but that is subject to yet one more limitation...

 

 

Test 3:

 

Now, even if you meet those 2 tests, you still must itemize to get the benefit. In other words, if that 8,000 was the only itemized deduction you had, you would be better off to take the standard deduction, which in 2012 is $11,900 for married filers, that is assuming you are married...(comic relief in the midst of mumbo jumbo). (Other itemized deductions to lump with the hobby losses are property taxes, mortgage interest, etc.) Assuming you don't itemize, end result: 10,000 hobby income, ZERO expenses...sigh...

 

 Assuming you had other itemized deductions that would cause you to itemize, you would get to deduct $8,000 of hobby losses while also still showing 10,000 of hobby income.

 

 

Again, there are many factors to consider here--the most obvious being "are you continually reporting losses" and are you (in the IRS' eyes) "irrationally" continuing to do this "business" because you think "someday, somewhere over the rainbow" consumers will pay what the cakes are worth and allow you to turn a legitimate business profit that leads to a black bottom line. (Note: Start-up costs are a whole separate deal.)

 

In general, if your activity is posting losses as a business for a number of years, the IRS may argue that you are not engaged in an activity for profit and must report all gross income as hobby income; in most cases, you won't get the benefit of the hobby losses due to the three tests/limitations described above. In no case, however, will you be able to deduct a net hobby loss as you would a net business loss.

 

In my limited, and I emphasize limited, research related to how advertising affects this, it seems to just be one of many factors considered. If you have any questions, you need to take your specific situation to a C.P.A. who can look at your gross numbers, expenses, length of time doing this, and your overall situation (do you have a day job, how much time do you spend 'caking' etc.) to determine if the activity should be classified as a hobby.

 

None of this is intending to be professional advice; it's just food for thought from a bean counter that is just trying to survive grad school! It is information to help you to engage your CPA to make the correct legal determination for your situation. Please be proactive. Once you sign the return, you are validating the information and stance contained therein.

I don't know much about the laws, but even if the IRS doesn't care, doesn't the Department of Ag?  It is a food item, not jewelry or something.  It could be hazardous.  And yes, I know people say "I keep my kitchen cleaner than any restaurant".  True as that may be, they have a legal license to sell food and insurance to stand on if something goes wrong. 

We have the exact same discussion at this moment in the Netherlands. We have similar regulations on what our taxauthorities define business vs hobby.

 

I personally believe that when you start to bake for complete strangers, and you bake more than 2 or 3 cakes per month and you profile yourself with a website and/or business FB page, the general public will perceive you as a business. When that happens you transcend from a hobby to a business, no matter what you tell yourself to justify your choices.

Whether or not the transaction is legal is irrelevant according to the IRS. In fact there is a line on Form 1040 specifically for reporting income from illegal activities, including bribes, drug dealing, and stolen property (reported as fair market value in the year you steal it).

The IRS's treatment of hobby income is so disadvantageous, if you have any significant income from a hobby you are usually better off making it into a business.