Everyone has heard the statement that you should work at what you love. Being able to work everyday at something for which you hold great passion is a dream few people get to fully realize. That does not mean that it is not possible though and pursuit of such a dream is a good thing.
Unfortunately, having a passion for some endeavors may not ultimately rise to the level of a trade or business and, in those cases, the Internal Revenue Service (IRS) will generally characterize the activity as a hobby, rather than a real business. Such characterizations happen regularly for activities such as automobile or motorcycle racing, dog or horse breeding, coin or stamp collecting, photography, etc. As might be imagined, such characterizations often carry profound tax effects for those conducting the hobby.
For tax purposes, a hobby is an activity in which the taxpayer engages in primarily for a purpose other than to make a profit. Because hobbies are not businesses, hobbyists cannot take the tax deductions to which business people are entitled. Instead, hobbyists can deduct their hobby-related expenses only from the income the hobby generates. If there is no income from the hobby, there is no deduction. And taxpayers cannot carry over the deductions to use in future years when you earn income—they are lost forever.
Even if a taxpayer has income from an activity that constitutes a hobby, he or she must deduct the associated expenses in a manner that is far less advantageous (and more complicated, as well) than regular business deductions.
Hobby expenses are deductible only as a Miscellaneous Itemized Deduction on Internal Revenue Service Schedule A, Itemized Deductions (the form that used to claim itemized deductions). This means that taxpayers can deduct their hobby expenses only if they itemize deductions instead of taking the standard deduction. They can itemize deductions only if their total deductions are greater than the standard deduction. If they do itemize, their hobby expenses can be used to offset their hobby income—but only to the extent that these expenses plus their other miscellaneous itemized deductions exceed 2% of their adjusted gross income (your total income minus business expenses and a few other expenses).
This is, of course, a severely limiting provision of the Internal Revenue Code and is likely to minimize, or eliminate, the ability to deduct valid expenses incurred in a hobby activity for any year. Not being able to deduct the expenses due these limitations does not mean that the hobbyist can exclude the income earned in the hobby for the tax year. Thus, the hobby classification results in the inclusion of the income and possible exclusion of any deductions.
The IRS has issued a Fact Sheet providing taxpayers with information concerning the differences in the tax treatment of deductions for activities engaged in for profit and those that constitute hobbies. In general, if the IRS determines that an activity is not profit-driven, deductions from the activity will be severely limited, as noted above, to the amount of income the activity generates. Losses from such activities cannot be used to offset other income, such as salary or investments.
To distinguish between a hobby and a business, it is important to take into account all the facts and circumstances of a particular situation. The IRS lays out the following nine (9) factors that should be considered when establishing if an activity is a business engaged in making a profit:
- Whether you carry on the activity in a businesslike manner
- Whether the time and effort you put into the activity indicate that you intend to make it profitable
- Whether you depend on income from the activity for your livelihood
- Whether your losses are due to circumstances beyond your control, or are normal in the startup phase of your type of business
- Whether you adjust your methods of operation in an attempt to improve profitability
- Whether you (or your advisors) have the knowledge needed to carry on the activity as a successful business
- Whether you were successful in making a profit in similar activities in the past
- Whether the activity makes a profit in some years, and how much profit it makes
- Whether you can expect to make a future profit from the appreciation of the assets used in the activity
Taxpayers must be prepared to show that an activity that generates deductions is a business from which the taxpayer intended to profit. It is not necessary that the activity actually earn a profit, so long as a profit was one of the motives for participating in the activity. To make this determination, the IRS considers all the surrounding facts and circumstances to judge whether activities are more like a business with a profit motive or are for personal satisfaction.
The IRS has said that it will assume that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year, or at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses.
Running the business of your dreams requires care to ensure that it does not ultimately end up being classified as a hobby. Should you have questions regarding the application of the tax rules to your particular facts and circumstances, please contact Bob Grossman or Don Johnston.
