Hobby vs. Business: Why the IRS Cares About Your Etsy Shop
- Lauren Twitchell
- Oct 2, 2025
- 3 min read
You sell on Etsy. Maybe it started as a creative outlet, maybe it’s turned into a full-time gig. Either way, the IRS has a question for you: is this a hobby or a business?
The difference isn’t just semantics. It’s tax law. And if you get it wrong, it can cost you money—or worse, raise red flags in an audit.
This post will break down:
How the IRS decides between hobby and business.
Why it matters for Etsy sellers.
What you can do to protect yourself.
The IRS Hobby Loss Rule
The IRS has a simple way of looking at side income: if you’re making money but not running it like a business, they may classify it as a hobby.
Here’s the key rule:
Businesses can deduct expenses.
Hobbies can’t.
That means if the IRS decides your Etsy shop is “just a hobby,” you lose the ability to write off materials, supplies, fees, and other costs.
How the IRS Decides
The IRS uses a list of factors (not just one test). Here are the big ones:
Profit Motive
Are you trying to make a profit, or just doing it for fun?
Recordkeeping
Do you keep books, track expenses, reconcile accounts?
Time and Effort
Are you putting in consistent work to grow your shop?
Expertise
Have you studied business practices or sought advice?
Profit History
Do you show profit in at least 3 out of 5 years?
No single factor decides it, but together they paint a picture.
Why Etsy Sellers Should Care
Etsy shops often start small and informal. You sell a few crafts, get excited, and before you know it you’ve made $10,000 in sales in a year.
But if you’re not treating it like a business—clean books, separate bank account, pricing for profit—the IRS could argue it’s a hobby.
The risk?
You lose your deductions.
You owe more tax than expected.
You draw audit attention for “hobby loss.”
Common Mistakes That Look Like Hobby Activity
Etsy sellers often make these mistakes without realizing how they look to the IRS:
Mixing personal and business money. Using one bank account for everything.
Sloppy or missing records. No tracking of fees, COGS, or sales beyond deposits.
Chronic losses. Reporting losses year after year without showing steps to improve.
No marketing or growth plan. Treating sales as passive rather than running it like a business.
On their own, these might not trigger reclassification. But stack them up, and they tell the IRS a story: “this is just a hobby.”
The IRS Angle: What I Saw as an Agent
When I worked for the IRS, hobby vs. business cases came up all the time. Agents didn’t look for perfection—they looked for intent.
If a taxpayer could show:
Separate accounts,
Real bookkeeping,
A reasonable effort to make profit,
then we treated it as a business, even if the margins were slim.
But if someone showed up with no records, no receipts, and losses for five years in a row? It looked like a hobby. And deductions got denied.
How to Protect Your Etsy Shop
The fix isn’t complicated. Here’s how to show the IRS you’re running a real business:
Separate Accounts
Have a dedicated business bank account. No mixing.
Keep Clean Books
Track sales, fees, and expenses consistently. Reconcile to your bank.
Track COGS
Know what each item costs to make. Don’t wing it.
Show Effort to Grow
Document marketing, advertising, or new product launches.
Aim for Profit
Even small profit matters. The IRS wants to see intent, not perfection.
Case in Point
One Etsy seller I cleaned up for had reported losses three years in a row. She was ready to quit. But after cleanup, we found she had actually been profitable—she just wasn’t logging expenses correctly.
Her corrected return showed a small profit, and the hobby risk disappeared. Clean records literally saved her business.
Final Word
The IRS doesn’t hate Etsy sellers. But they do expect you to treat your shop like a real business if you want the tax benefits of one.
Hobby vs. business is about proof. Clean records, separate accounts, and profit intent show the IRS you’re serious.
No judgment. No fluff. Just clean books.
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