Business vs. Hobby: How the IRS Decides If Your Freelance Activity Is a Real Business
The IRS does not care about labels. Calling an activity a “business” on Schedule C doesn’t make it one. The IRS applies a nine-factor test from the regulations under IRC 183 to determine whether an activity is engaged in for profit (a business, with deductible losses) or not engaged in for profit (a hobby, with losses that can’t offset other income). For freelancers, this distinction matters most in the early years when expenses exceed revenue, or in situations where the freelance activity is a side pursuit alongside a full-time job.
The IRC 183 “hobby loss” rule applies when the IRS suspects that a Schedule C activity isn’t conducted with a genuine profit motive. The presumption: an activity that shows a profit in 3 of the last 5 years (2 of 7 for horse activities) is presumed to be a business. An activity that doesn’t meet this presumption may still be a business if it passes the nine-factor test. The nine factors (no single factor is determinative): (1) manner the activity is carried on, (2) expertise of the taxpayer, (3) time and effort spent, (4) expectation that assets will appreciate, (5) taxpayer’s success in similar activities, (6) history of income or losses, (7) amount of occasional profits, (8) financial status of the taxpayer, and (9) elements of personal pleasure. Hobby income is taxable, but hobby expenses can’t offset other income (they could be deducted as miscellaneous itemized deductions before 2018, but the TCJA suspended that deduction and the OBBBA made the suspension permanent). A freelancer classified as a hobbyist pays tax on revenue but can’t deduct losses, which is the worst possible outcome.
What triggers the hobby loss examination?
The IRS is most likely to examine the hobby loss question when:
- The freelancer reports losses on Schedule C for 3+ consecutive years
- The freelancer has substantial W-2 income from another job (the Schedule C losses offset the W-2 income, reducing total tax)
- The activity has a personal pleasure component (photography, art, writing, music, travel blogging)
- The losses are large relative to the revenue
How to pass the nine-factor test
Factor 1: Manner of carrying on the activity. Operate like a business: separate bank account, business cards, invoicing, contracts, organized records, insurance. A freelancer who tracks income and expenses in a spreadsheet, maintains a portfolio, and has a professional website looks more like a business than one who casually accepts occasional gigs.
Factor 2: Expertise. The freelancer has training, education, or experience in the field. A photographer who completed a degree in photography or attended professional workshops has stronger standing than a hobbyist with a new camera.
Factor 3: Time and effort. The freelancer devotes regular, consistent time to the activity. A side freelancer who works 10-15 hours per week on the business (marketing, client work, administrative tasks) shows more commitment than one who works sporadically.
Factor 4: Expectation of asset appreciation. If the activity involves assets that may appreciate (real estate, art, inventory), the expectation of appreciation can support a profit motive even during years of operating losses.
Factor 5: Success in similar activities. If the freelancer has successfully run a similar business in the past, this supports a profit motive.
Factor 6: History of income or losses. Losses in early years followed by increasing revenue shows a trajectory toward profitability. Consistent losses with flat or declining revenue suggests no profit motive.
Factor 7: Amount of occasional profits. An activity that generates a small profit in one year and large losses in others may not have a genuine profit motive. Occasional large profits relative to the investment support a business classification.
Factor 8: Financial status. If the freelancer’s other income (W-2 salary, investments) is substantial and the losses offset that income, the IRS may argue that the activity exists to generate tax losses rather than profits.
Factor 9: Elements of personal pleasure. Activities with inherent personal pleasure (photography, art, horse breeding, travel blogging) receive more scrutiny. This doesn’t disqualify the activity, but it adds a burden to demonstrate that profit, not pleasure, is the primary motive.
No single factor is determinative. The IRS evaluates all nine factors together. A freelancer who operates professionally (Factor 1), has expertise (Factor 2), devotes significant time (Factor 3), and shows a trajectory toward profitability (Factor 6) is likely a business even if the activity also provides personal pleasure (Factor 9).
Related guides:
- Freelancer 1099 Reporting Requirements
- Freelancer Estimated Taxes Quarterly Payments
- Freelancer Health Insurance Deduction Self Employed
- Freelancer Home Office Deduction
- Freelancer International Clients Tax
Do I need to collect sales tax on my services?
Whether services are subject to sales tax depends entirely on the state where the service is performed or delivered. Most states exempt professional services (accounting, legal, consulting) from sales tax, but a growing number tax specific services like repair and maintenance, landscaping, and personal care services. Some states tax all services unless specifically exempted, while others exempt all services unless specifically listed as taxable. If you operate in multiple states, you need to check each state’s rules because a service taxable in one state may be exempt in another. Failing to collect and remit required sales tax creates a personal liability for the business owner, and states can audit back several years with penalties and interest.
Related guides:
Start with a Diagnostic: a CPA licensed in the US and Canada reads your file and tells you in writing what's wrong and how to fix it, three to four business days after you finish the questions. The report is $250. If you hire us for any work after that, you get the $250 back as a discount on that work. Or send us your return or your letter and get a fixed price, free.
One or two plain-English guides a week on US-Canada tax. No spam, unsubscribe anytime.
Done. The next guide will land in your inbox.
Yarik Yarosh, CPA. "Business vs. Hobby: How the IRS Decides If Your Freelance Activity Is a Real Business." Blue Cloud CPA, September 5, 2026. https://bluecloudcpa.com/guides/freelancer-business-vs-hobby-irs-test
This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.