The Focus - Our Tax E-Newsletter
Hobbies: When they're none of your "business"!
As you reminisce about your childhood, think about the little activities you would engage in for fun and to pass time. Maybe it was toy trains, collecting baseball cards, dolls, stuffed animals or even pet rocks! In the glory days of our youth, those activities were our "hobbies".
As we get older, we still have hobbies. In the ultra-capitalistic society in which we live, it is only natural for one's entrepreneurial instincts to take over. So perhaps now we look for ways to turn those hobbies into some additional income. You may also have expenses or deductions that can offset that income. The result: you have now turned your "hobby" into a "business". Or have you? And what is the difference?
The determination of whether an individual is engaged in a hobby or has established an "active trade or business" has wide-ranging tax implications. Self-employment tax, IRA and other retirement plan contributions, self-employed health insurance deductions, depreciation deductions (Section 179), limitations on deductions or tax credits imposed by adjusted gross income are just a few of the items potentially impacted. For these reasons, the issue of hobby vs. business continues to be one of the most controversial, frequently challenged areas of individual tax law.
So when is a "hobby" a "business" and vice versa? The so-called "hobby rules" are governed by Internal Revenue Code (IRC) Section 183 and the Income Tax Regulations thereunder. Generally an activity is not engaged in for profit, and therefore commonly referred to as a "hobby" if the activity is other than one in which deductions are allowable as expenses of carrying on a trade or business (IRC Section 162) or incurred for the production, collection, management, conservation of income or income producing property (IRC Section 212).
Although all facts and circumstances with respect to an activity are taken into account, the Regulations identify nine relevant factors to be considered to determine whether an activity is engaged in for profit. No one factor is determinative and the Regulations state that the list of factors are not all-inclusive, but they are factors that normally should be considered:
- Manner in which the taxpayer carries on the activity. Does the taxpayer carry on the activity in a business-like manner and maintain complete and accurate books and records? Does the taxpayer change operating methods and/or adopt new techniques or policies to improve profitability? Affirmative answers to both questions may indicate a profit motive.
- Expertise of the taxpayer or his/her advisors. Preparation for the activity through additional education or self-study as to accept business, economic and scientific practices related to the activity, and consultation with experts may indicate a profit motive. Where the taxpayer does not carry on the activity in accordance with such practices and does not do so in an attempt to develop new, more profitable techniques may indicate a lack of profit motive.
- The time and effort expended by the taxpayer in carrying on the activity. If the taxpayer devotes much of their personal time and efforts to carrying on the activity or withdraws from another occupation to devote more time to the activity, may indicate a profit motive. However, devoting limited time is not necessarily indicative of a "hobby", especially if the taxpayer employs others to assist in the activity.
- Expectation that assets used in an activity may appreciate in value. "Profit" is not only considered the excess of revenue over expenses. It also includes appreciation in the value of assets, such as real estate or investments. Even if no profit is generated from the current operations, an overall expectation that the ultimate appreciation in the assets used in the activity will exceed expenses of the operation may indicate profit motive.
- Success of the taxpayer in carrying on similar or dissimilar activities. Has the taxpayer engaged in activities in the past and converted them from unprofitable to profitable ventures? If yes, this may indicate that the taxpayer is engaged in their present activity even though the activity might be currently unprofitable (i.e. generating losses).
- Taxpayer's history of income and losses with respect to the activity. This is perhaps the most highly contested of the nine factors. Most "start-up" business endure losses in their early years as a result of the expenses required to get "up and running" before revenues are generated. A series of losses during this phase is not necessarily an indication of a lack of profit motive. However, continued losses beyond a reasonable period which are unexplainable, such as those caused by depressed market conditions or conditions beyond the control of the taxpayer (i.e. weather or other natural disasters), may be an indication that the activity is not engaged in for profit.
- Amount of occasional profits, if any, which are earned. While generating net profits from the activity is generally indicative of a profit motive, the size of the profits in relation to the size of previous losses is a considered factor. An occasional small profit from an activity generating large losses, particularly where the taxpayer has made a large investment, might indicate lack of profit motive. Conversely, larger or more substantial profits, even though infrequent, may indicate profit motive especially where the taxpayer's investment is relatively small.
- Financial status of the taxpayer. If the taxpayer is engaged in an activity that provides a substantial portion of their income and/or capital resources may indicate profit motive. If the taxpayer has substantial wherewithal from other activities may be an indication that the activity is not engaged in for profit.
- Elements of personal pleasure or recreation. Carrying on an activity that has substantial personal and/or recreational elements may indicate lack of profit motive. Since we can all "love what we do", the determinative impact of this factor is generally analyzed as a component of several of the other factors (particular the time and effort and financial status factors).
The burden of proof is on the taxpayer to establish the requisite profit motive to have the activity not deemed a "hobby". A statutory safe harbor exists to shift the burden of proof to the IRS. If the activity generates a profit in at least three of the last five years (two out of seven for certain activities related to horses), the burden of proof for lack of profit motive shifts to the IRS.
If you think that your favorite "hobby" can qualify as an "active trade or business" and you might even be able to derive some tax benefits in the form of losses which can offset other income, feel free to contact your DB&B advisor to discuss the tax implications at the outset, so that you do not find yourself between a (pet) rock and a hard place down the road!
The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.