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Game lawyer Zachary Strebeck looks at the IRS distinction between businesses and hobbies, and how that affects an indie developer’s taxes.
For many indie game developers, creating games is just a “hobby.” However, there are a growing number of developers who want to transition this thing that they love, game development, into a full-fledged business.
Usually, we use casual definitions of these terms. Something you do for fun is a hobby, and something that you’re selling is a business. There are lots of instances where developers want to be able to deduct expenses from their taxable income, though.
When it comes to taxes, the IRS has their own ideas about what constitutes a hobby or a business. According to their fact sheet on the subject, as much as $30 billion a year is lost to the government by incorrect classification of expenses. You can see how they might be a bit upset.
Guess what – determining whether you’re engaging in a hobby or a business is more complicated than you would think (isn’t it always?).
First of all, the IRS defines a “business” as a venture that has a reasonable expectation of profit. Here’s where it gets complicated, though. There’s a big list of questions you need to ask yourself when making the determination. These include:
Are you dependent on the income from the “business”?
Do you put enough time and effort into the “business” to make a profit?
Do you have the requisite knowledge to actually have a successful business in that field?
There’s a bunch more, so check out the IRS fact sheet to get the whole picture.
If you’re in it only for recreation and not for profit (you didn’t meet the tests above), then what you’re doing is only considered a “hobby.”
The IRS allows expenses that are “ordinary and necessary” in the course of business to be deducted from taxable income. If you’re a sole proprietor or a single-member LLC, you will be making these deductions on your personal tax return. Before deducting expenses, you should be well-versed in what constitutes ordinary and necessary (or get a tax advisor to do it).
Ordinary: an expense that is common and accepted in your industry
Necessary: an expense that is appropriate for the business
What does it mean that something is “appropriate”?
That depends on the particular industry, of course. You would have to look to the activity of others in that field.
If you don’t meet the definition of a “business,” you can deduct types of hobby-related expenses that are ordinary and necessary for that hobby. However, there are limits to how much you can deduct. Most important is that you can’t deduct any more than the amount of income you’ve received from that hobby.
So if you make a game as a hobby that only receives $100 in the year from sales, you can’t deduct the $75 per month you’ve paid for a Unity license, for example. With a business, you would be able to deduct those losses from your other income. A hobby does not allow that.
There are other limitations to the deduction of hobby income. See the IRS fact sheet for more information.
For more information on your tax responsibilities as far as your indie games business goes, check out these great books by tax pro Mike Piper [the links are affiliate links to support the blog]:
Better yet, get yourself a real, live tax advisor. If you’re running a business, you owe it to yourself to do things the right way.
Do you have any questions about the business or tax aspects of running an indie game development studio? Ask them in the comments!
this article was originally posted on The Game Lawyer Blog
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