Do You Have a HOBBY or a BUSINESS?

The Tax Cuts and Jobs Act has eliminated the deduction of expenses for a hobby with the change to the Schedule A (which eliminates the entire section of expenses subject to the 2% threshold).

This has made the determination of whether you are engaged in a business or hobby  even more critical. In the past, certain hobby expenses were deductible to the extent that there was income. Unlike an entity that is considered a for-profit business in which the expenses can exceed income, hobby expenses were only allowed to the extent of reported income.

In determining whether an activity is a hobby or business, we consider all facts and circumstances of the activities. Following are some items that are considered when making the determination:

  1. The manner in which the taxpayer carries on the activity: Factors that may indicate a business include maintaining books and records, obtaining business licenses, having a website, conducting the activity similar to other businesses, and changing operating methods and techniques to improve profitability.
  2. The expertise of the taxpayer or their advisors: Factors that may indicate a business includes the knowledge of the taxpayer (or their consultants) about the industry.
  3. The time and effort expended by the taxpayer in carrying on the activity: If you commit a considerable amount of time and effort in the activity, especially if there is no substantial personal or recreational aspect, is considered. Taking time away from another occupation may also indicate a profit motive. Spending little time may not be counted against you if there are employees qualified to conduct the business activity.
  4. The expectation that assets used in the activity may appreciate in value: Even if no profit is made from operations, if the value of land or other assets in the activity appreciate so that an overall profit is made from a sale, the activity may be considered a business.
  5. The success of the taxpayer in carrying other similar or dissimilar activities: If you were successful in the past turning an unprofitable venture into a profitable venture, the current activity may be a business even if it has not yet made a profit.
  6. The taxpayer’s history of income or losses with respect to the activity: Early losses during the start-up phase is to be expected, however, continued losses that are not explainable may indicate a hobby.
  7. The amount of occasional profits, if any, which are earned: The amount of profits in relation to the amount of losses, and in relation to your investment in the activity, may indicate intent. An occasional small profit one year, mixed with large losses in other years or large taxpayer investments, may indicate the activity is a hobby. Substantial occasional profits mixed with frequent small losses or investment may indicate a business. An opportunity to earn substantial ultimate profits in a highly speculative venture also indicates a profit motive.
  8. The financial status of the taxpayer: If you do not have substantial income or capital from other sources, there may be a profit motive. If you have substantial income from other sources, and losses from the activity in question generate substantial tax benefits, you may not be considered to have a profit motive.
  9. Elements of personal pleasure or recreation: Where there are recreational or personal elements involved with the activity, a lack of profits may indicate a hobby. On the other hand, a lack of any appeal in the activity other than possible profits indicates a profit motive. It is not necessary that the sole purpose for engaging in an activity is to make a profit. The availability of other investments that might produce a higher rate of return will not count against the taxpayer. The fact that you derive personal pleasure  in the activity is not sufficient in itself to classify the activity as a hobby if other factors indicate the activity is a business.

Occasional profits from hobby activities are not subject to self-employment tax and are reported as other income on Form 1040. Under the Tax Cuts and Jobs Act, for tax years 2018–2025, expenses related to hobby income are not deductible as miscellaneous itemized deductions subject to the 2% AGI limit on Schedule A (Form 1040).

Activities Not Engaged in for Profit

IRS examiners consider the following in their analysis to determine whether or not an activity is engaged in for profit:

  • Are there activities with large expenses and little or no income?
  • Are losses offsetting other income on the tax return?
  • Does the activity result in a large tax benefit to the taxpayer?
  • Does the history of the activity show that it is generating any profit in any years?

Examples of possible hobby activities include:

  • Airplane Charter
  • Games
  • Artists
  • Gardening
  • Auto Racing
  • Horse Breeding
  • Boating
  • Horse Racing
  • Bowling
  • Jewelry Making
  • Collecting
  • Knitting
  • Cooking
  • Motocross Racing
  • Craft Sales
  • Music
  • Direct Sales
  • Outdoor Recreation
  • Dog Breeding
  • Photography
  • Entertainers
  • Rentals
  • Farming
  • Stamp Collecting
  • Fishing
  • Woodworking
  • Fishkeeping
  • Writing
  • Gambling
  • Yacht Charter

Burden of Proof

IRS rules state that if an activity is profitable in three of the last five tax years, including the current year, the presumption is it is carried on for profit, and the hobby loss limitations do not apply. The burden of proof is on the IRS to show the activity is not a business. If the activity consists primarily of breeding, training, showing, or racing horses, the IRS will presume it is carried on for profit if a profit is produced in at least two of the last seven tax years, including the current year. If the activity shows a loss in three of the last five tax years, then the burden of proof is on the taxpayer to show that the activity is a business and not a hobby.

The rules in this area are complex. We encourage you to contact our office if you have any questions regarding your business activities and how to avoid your activities possibly being reclassified as a hobby.

 

Originally published in the NSTP Client Newsletter (Fall 2018)