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In general, in order to file a Schedule C and deduct all your business expenses, you must have been engaged in a "trade or business;" that is, an activity that is carried on for a livelihood or for profit.
A profit motive must be present (though you may, in fact, have experienced a loss for the year) and some type of economic activity must be conducted. "Profit" for purposes of these business activity rules means real economic profit, not just tax savings. This profit motive is what separates a business from a hobby, which is an activity engaged in purely for self-satisfaction.
If you are in business with the objective of making a profit, you can generally claim all your business deductions. If your deductions exceed your income for the year, you can claim a loss for the year, up to the amount of your income from other activities. Remaining losses can be carried over into other years.
What's so bad about hobbies? Well, if you are in business with the objective of making a profit, and your deductions exceed your business income for the year, you can claim a loss up to the amount of your total income from all activities. Remaining losses can be carried over into other years.
Your ability to deduct these losses will be limited if the IRS considers your "business" to be a hobby.
Hobby expenses incurred by individuals and even by partnerships and S corporations are generally deductible only to the extent of the income produced by the hobby. In other words, you can't use a hobby to generate a tax loss that can be used to shelter your other income.
Some expenses, however, that would be deductible on your individual tax return regardless of whether they are incurred in connection with a hobby (such as real estate taxes, mortgage interest, and casualty losses) are deductible even if they exceed your hobby income. These expenses must be used to reduce the amount of the hobby income from which your other hobby expenses can be deducted.
Every bit of your hobby income is reported as "other income" on Line 21 of your Form 1040, Individual Income Tax Return. However, expenses associated with the hobby are only deductible if you itemize your deductions. What's more, they are considered "miscellaneous itemized deductions" and you can only deduct the portion of them that, along with any other miscellaneous deductions, exceeds 2 percent of your adjusted gross income.
Although the IRS is not limited in the kind of businesses that it can challenge as being hobbies, businesses that look like traditional hobbies (such as "gentlemen farming" and craft businesses run from the home) may well face a greater chance of IRS scrutiny than other types of businesses.