My first article about hobby losses discusses how and why your sole proprietorship, partnership or S-corporation may be reclassified as a hobby for tax return purposes. This is a totally different from making crafts as a hobby. A hobbyist doesn't intend to operate a business; this is something you do just for fun and maybe to give as gifts or use yourself. Nothing wrong with that. Additionally, most arts and crafts businesses have their origin in a hobby the eventual business owner enjoyed.
However, what if you operate an arts and crafts business as a sole proprietorship or flow through and your business loses money year after year. Well, if your tax return is selected for audit by the Internal Revenue Service (IRS) and they find you don't have a serious business intent, the way you report your craft sales and expenses on your tax return changes and it usually will increase the amount of income tax you'll have to pay.
Reporting Arts and Crafts Hobby IncomeGross receipts from your hobby sales are reported on page 1 of Form 1040 as other income on line 21. This adds to your adjusted gross income. However, it's usually not subject to self-employment tax - only income tax - if your hobby making activity is not continuous or regular or meant to turn a profit (even if you do so occasionally). Ok, simple enough you may be saying - what's the catch?
Reporting Arts and Crafts Hobby Expenses
Well, the catch comes in because you must itemize hobby expenses on Schedule A. If you don't have enough other deductions to itemize, you've lost the entire expense deduction. You are also not allowed to deduct hobby expenses on the Schedule A in excess of your gross arts and crafts hobby income. And, hobby expenses are among the deductions subject to the 2% of the adjusted gross income floor.
So, let's say you make jewelry and your customers pay you $1,000. Your raw materials to make the jewelry and your jewelry-making office expenses such as packing material, printer paper and toner total $1,200. Your first limitation when deducting your expenses is your jewelry sales income limit of $1,000. Your second limitation comes into play with your adjusted gross income. If your adjusted gross income is $40,000, 2% of that is $800. You can only deduct $200 in expenses ($1,000 - $800 = $200).
As you can see, expenses that originally total $1,200 are only reducing your taxable income by $200. For more information about deducting hobby expenses, check out IRS Publication 535.