Taxpayers often dream about using a hobby, like collecting stamps, for a tax deduction, but the Internal Revenue Service won't let this happen unless it is also a business. Turning your hobby into a business can provide the tax breaks a regular company receives, but you probably end up paying more to Uncle Sam and may regret monetizing your passion.
If you pursue an activity as a hobby, you can only deduct expenses against your income from the activity. For instance, if you earn $3,000 refurbishing cars and had $10,000 in expenses, you can only deduct $3,000 in expenses. Turning the hobby into a business allows you to deduct any qualified expense, but you also have to pay your payroll taxes and prove it is a business. In general, you have to act like your hobby is a business, such as by having records and employees, and turn a profit in most years. In 2011, the self-employment tax rate is 13.3 percent, but as an employee, you only pay half of that. You never pay self-employment tax on a hobby.
You will have to make every decision related to your hobby like a businessman, which may take some of the joy out of your former hobby. For instance, if you buy and sell coins, you might have to spend a few hours keeping receipts and writing a log for your expenses while at a convention. You also have to research your business model to ensure it is viable before you quit your job. In addition, the idea has to be profitable enough for you to live off as well, and it must be competitive five and 10 years down the road.
Pursuing your hobby as a business probably means expenses you didn't have as a hobbyist. For example, if you like to mix drinks on the weekend and now want to start your own bar, you probably need tens of thousands of dollars to design your bar and acquire the appropriate licenses and materials. Owning a business also usually means working more than you did at your regular job, at least until you can afford to hire employees.
Starting a business is a major life change, so you should go to an accountant or financial planner to talk about how it will affect your future, such as taxes and savings. If you are a sole proprietor, for instance, you will have to file estimated taxes every three months. Also talk over the idea with your spouse. If you have small children, for instance, you might want to hold off the venture until they require less attention.