Realistically, we all know woodworking hobbyists who sell a piece or two each year without reporting the extra income. But that doesn't make it right, or wise.
If you sell any of your work, you're subject to tax laws. Ignoring those laws puts you in peril should the Internal Revenue Service or state tax officials find out about it.
True, budget cutbacks and increasing congressional scrutiny have tamed IRS agents in recent years. State auditors, though, especially sales tax auditors, are more numerous and often keen on ferreting out the underground economy in crafts. And if the state catches someone, it can turn that person in to the IRS, too.
Regardless of who's doing the most checking, honesty is always the best policy on your part. Trouble is, tax laws don't make honesty easy. Rules surrounding enterprises like woodworking—that frequently straddle the line between hobby and business—can seem confusing.
Having your woodworking treated as a business for tax purposes has two advantages. One, you're allowed to deduct costs for equipment and workshop space. And two, you also can deduct any losses from your woodworking business against income from your day job.
The IRS is wary, however, of part-time woodworkers who try to classify themselves as businesses. If you're actually clearing a profit and you're not writing off the cost of your woodworking equipment, this shouldn't be a problem. But if you've had a loss or you're writing off equipment costs, you could face closer scrutiny, including an audit of your income-tax records.
Generally, the tax folks classify your woodworking as a business if:
You have made a profit from it in three of five consecutive years.
You operate in a businesslike manner (for instance, by keeping complete financial records).
Woodworking is your major source of income.
Sideline woodworking businesses, however, rarely meet all three standards. Yet, hobbyists still need to report income from sales, less the costs of materials that went into what they sold. But you can't deduct costs for running your workshop, such as electricity. And it's unlikely that you'll be able to deduct costs for equipment. If you do, you can deduct only the portion that exceeds two percent of your regular income, and you'll need to keep detailed records so you deduct only for the percentage of time you used the equipment for business (as opposed to hobby use).
Remaining a hobby woodworker isn't bad, though, tax-wise. Consider just this: You won't have to pay self-employment tax, which amounts to about 13 percent when income exceeds $400. For example, let's say you're in the 28% tax bracket from your day job, sell $2,000 worth of furniture that you built (after deducting material expenses) and could deduct $500 of equipment expenses under business tax rules. If taxed as a hobbyist, you'd pay $560 in income taxes on that $2,000. If taxed as a business, though, you'd pay $615 in combined income and self-employment taxes. Tax forms for businesses are more complex, too, meaning you'll pay more for tax preparation.
Whether your woodworking qualifies as a hobby or a business for tax purposes, here are some things you should do:
Keep records and receipts of all income and expenses associated with your woodworking activity.
If you think your woodworking qualifies as a business, get form 1040-ES by calling 1-800-TAXFORM, and follow the instructions to pay quarterly estimated taxes so you aren't surprised or penalized come April.
Contact your state's department of revenue for rules governing state and local sales taxes.
Get advice from a tax preparer, accountant, or registered agent.
Written by Jack Neff, a Batavia, Ohio, business writer and author of Make Your Woodworking Pay for Itself.