How many people have a dream, a passion, or a vision that turns into a business on the side? Maybe one day that side business will turn into a full-time enterprise, but for now getting started is good enough. Even if the business loses money at first, the dream is alive, and besides, the business loss is deductible. Or is it?
Those who own their own businesses may need to determine if the IRS could consider those businesses to be hobbies. Many hobbies turn into businesses, but the IRS may disallow some or all business deductions if the business activity is determined to be a hobby for tax purposes. Common examples of the types of businesses that the IRS may determine to be a hobby include, but are not limited to, fishing; horse breeding, training, or racing; farming; craft sale; stamp collecting; photography; writing; and dog breeding.
To determine if a business activity is a hobby, the IRS looks at whether the activity has a profit motive. The simple assurance of the taxpayer that a profit motive exists is not sufficient. Imagine that. If the IRS determines that a business activity does not have a profit motive, then no deductions are allowed for that business activity. If an activity shows a profit for at least three years of the last five consecutive tax years, it is presumed to be engaged in for profit. (Those in the horse business may need to show profit in only two out of the last seven years.) If the three-out-of-five-year test is met, and the IRS does not continue to assert that the business is a hobby, then business deductions are allowed to offset income even if the result is a taxable loss. If the three-out-of-five-year test is not met, then deductions are allowed only against the income from the activity as explained later in this article.
To determine if a business activity is engaged in for profit, one must examine the facts and circumstances of each case. The IRS regulations provide nine factors that need to be considered in determining if an activity is engaged in for profit. Many of the nine factors are subjective in nature and thus open to interpretation. They include the following:
1) Manner in which the taxpayer carries on the activity;
2) Expertise of the taxpayer or his/her advisors;
3) Time and effort expended by the taxpayer in carrying on the activity;
4) Expectation that assets used in the activity may appreciate in value;
5) Success of the taxpayer in carrying on other similar or dissimilar activities;
6) Taxpayer’s history of income or losses with respect to the activity;
7) Amount of occasional profits, if any, which are earned;
8) Financial status of the taxpayer; and
9) Elements of personal pleasure or recreation.
For an activity that is determined to be a hobby, expenses are not allowed as business expenses, but may be allowed as itemized deductions. However, they can be claimed as itemized deductions only to the extent of income produced by the activity and in a prescribed order. First, expenses incurred that are otherwise deductible, such as real estate taxes, may be taken as an itemized deduction. Second, expenses that would be deductible if the activity had a profit motive and that do not require a basis adjustment, including normal trade or business expenses, such as advertising, insurance, and utilities, may be claimed as miscellaneous itemized deductions. Finally, if the first two types of expenses have not offset the hobby income, then expenses which do result in a basis adjustment, such as depreciation expense, may be claimed as miscellaneous deductions.
The taxpayer receives a benefit for these expenses claimed as miscellaneous deductions only if her/his hobby expenses are more than two percent of adjusted gross income. Since these hobby deductions are subject to the 2 percent of adjusted gross income limitation, a taxpayer may end up with net taxable income from a hobby activity even though the allowable expenses equal the income from the activity. Since hobby expenses are deductible only as Schedule A miscellaneous itemized deductions, taxpayers who do not itemize deductions cannot claim any deductions attributable to a hobby activity. In addition, a taxpayer with significant hobby expenses may become subject to alternative minimum tax because miscellaneous itemized deductions are not deductible for alternative minimum tax.
Turning a dream into a business will require hard work and investment, and to make things worse, the IRS will not want the federal government to subsidize the effort with tax deductions if they determine that the business is a hobby. Knowing the rules may help keep a new business in the business column and off the roles of hobbies.
Melissa King, CPA
Tax Manager, Wilkerson Guthmann