Do you Run a Business…or a Hobby?

Originally published in the Cedar Street Times

January 10, 2014

I remember a number of years ago preparing a tax return for a woman who was employed part-time, but who also had a side business as an artist – a painter as I recall.  When I was preparing her Schedule C for the art business there were lots of expenses – art supplies and tools, framing expenses, office expenses, vehicle expenses, postage, dues and subscriptions, a home office deduction, meal and entertainment expenses, and lots of travel expenses.  In all it came to over $35,000.  When I got to the revenue side, however, only $400 was listed.  I thought it was a mistake – maybe missing a few zeroes on the end, so I gave her a call.  She said she just had a bad year and sold hardly anything.  “Okay,” I thought, “that is a pretty bad year. I wonder what a good year looks like for her?”

As the story unraveled, there was a history of growing expenses from $10,000 to $35,000 a year and a history of revenues in bad years of $0 to a few thousand dollars in the “good years.”   I could clearly see now what was going on – she must have had about the same natural talent for painting as me and her paintings were so ugly that they wouldn’t be hung in a dumpster, much less purchased.  Actually, that is not what I thought.  I believe she had a hobby as an artist, she loved to travel, and she developed an addiction for tax deductions when she married her art and travel on a Schedule C tax form!

The IRS is very much aware of this phenomenon, and section 183 of the Internal Revenue Code and its related regulations deal specifically with this area.  The rules are known affectionately as “hobby loss rules.”  The basic rule is that if you are not truly engaged in an activity for profit, then your deductions will be limited to your revenue.  This takes all the fun out filing a Schedule C in situations like this, since losses generated are disallowed and cannot offset other income on your tax returns.  If you get audited on the issue and lose, the IRS can go back and disallow the losses from past years, and then assess the tax you should have owed along with stiff penalties and interest that accrue dating back to the dates you should have paid the tax originally.  This can get very ugly.

So how can you safely assume you are engaged in an activity for profit?  Section 183 plainly tells us that if you are profitable in three out of every five consecutive years (two of seven for horse breeding), you are generally presumed to be engaged in an activity for profit.  Of course, if you have a pattern of reporting $200 of income for three years and then $100,000 of losses for the next two, they will not be that graceful towards you.

The meat of their determinations lie in a list of nine characteristics (albeit non-exhaustive) which they apply to your facts and circumstances.  The nine factors are: 1) are you carrying on the business in a business-like manner – records, formalities, changing tactics that don’t work, 2) do you have or did you hire necessary expertise – not only in your subject matter, but in running a successful business, 3) what percentage of your time is devoted to the business (more important with activities that do not have substantial personal or recreational aspects), 4) reasonable expectation that the assets may appreciate in value and offset the expenses, 5) the history of success in similar or dissimilar activities, 6) the history of the activity’s income and losses, 7) if you have occasional profits, how substantial are they, 8) do you have other sources of income, and is this activity providing tax benefits, and 9) how much personal or recreational pleasure is involved in the activity.

People in the arts have a higher level of scrutiny due to the common personal and recreational pleasure often involved.  In a 1977 court case (Churchman v. Commissioner) the court said, “[A] history of losses is less persuasive in the art field than it might be in other fields.”  They also concluded that music falls in their definition of arts.

As you are preparing for your tax returns this year, and if you know you have a business with a pattern of losses, you may want to examine yourself in light of these nine factors.  Keep in mind, however, that even if you lose money for a long time, as long as you can demonstrate over these characteristics, you can still be okay.  Oh, and regarding the client I worked with years ago – once I did a calculation and showed her the potential penalties and back taxes she could owe, she completely dropped the Schedule C altogether.

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

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