2019 – 05/23

Your passion for abstract painting brings you great joy. You’ve participated in art shows and even sold a few paintings to friends. You recently launched an instructional blog where you share tips and techniques. You think of painting as a part-time career. As your expenses for paint, studio space, and web hosting steadily increase, you want to deduct those costs as business expenses. But can you?

The answer comes down to whether painting is a hobby or a business. This can be a fine line distinction. Let’s explore what the IRS has to say about it.

A true grey area

Some years ago, the IRS became suspicious that taxpayers were treating their hobbies as businesses so they could deduct expenses and reduce their overall income. For someone with an expensive hobby/business, the tax impact could be significant. This situation gave rise to what are known as the hobby loss rules.

These rules help to separate non-business pastimes from business ventures. Just read a few court cases and you will find that this can be a grey area of the tax code. However there are some basic steps you can take to ensure that your legitimate business activity is not reclassified as a hobby.

The targets of the hobby loss rules are typically activities that are generating losses and involve some degree of pleasure, especially if the activities are not the primary source of income for the taxpayer. High income taxpayers that are operating “businesses” that are commonly known to produce losses are often the subject of these rules. Examples include artistic ventures, vineyards, horse breeding and other horse-related activities.

The burden of proof lies with the taxpayer to demonstrate that they are running a business, engaging in the activity with genuine profit motive. The risk is that IRS will reclass the activity as a hobby. Under the new tax law, expenses related to hobby activities are no longer deductible (for tax years 2018-2025). Additionally, the taxpayer takes the risk that previously filed returns will be reassessed and back taxes, penalties, and interest will be levied. Depending on the amount of losses taken over the years, this could be a substantial cost to the taxpayer.

Proving a business is a business

How do we avoid this reclassification of an activity as a hobby? There are two approaches: 1) the safe harbor method, and 2) consideration of nine factors defined by the IRS.

The safe harbor method requires that of five consecutive years at least three must produce a profit. There is an extended time period for certain specified industries. So if your dog breeding activity produces a profit in three of five years, it qualifies as a business.

The reality is that many start-ups struggle to produce income within this time constraint. Therefore, many taxpayers turn to the nine factors to demonstrate the business nature of the activity. These are not all-inclusive, but are the basis of most such cases.

The nine factors are:

  • The manner in which the taxpayer conducts the activity
  • The expertise of the taxpayer or his advisors
  • The time and effort expended by the taxpayer in carrying on the activity
  • Expectation that assets used in activity may appreciate in value
  • The success of the taxpayer in carrying on other similar or dissimilar activities
  • The taxpayer’s history of income or losses with respect to the activity
  • The amount of occasional profits, if any
  • The financial status of the taxpayer
  • Elements of personal pleasure or recreation

Treat a business like a business

Obviously, many of these factors have a subjective element. For instance, how much pleasure can you take in a business versus a hobby? The subtleties of some of these factors make it important to focus on the less subjective standards, especially the first, the manner in which the taxpayer conducts the activity. This means keeping adequate records, charging for goods or services, making efforts to attract customers, and genuinely operating the business in an organized, business-like manner.

Most advisors would encourage any business owner to keep a separate bank account for the activity, maintain books and records and prepare a business plan to profit. As an additional measure, some advisors encourage their clients to set up a separate LLC or similar entity to operate the activity.

Consistency is another key issue. To claim that the activity has a business purpose for income tax filings, and then claim no business activity for sales or personal property taxes can be detrimental to the argument for profit motive. The activity description and NAICS code should be consistent with the actual activities of the enterprise.

Because the burden of proof lies with the taxpayer to substantiate a profit motive, it is imperative to be familiar with the nine factors, keep adequate records, and consult a professional tax advisor. The cost of not doing so can be significant. While producing income every year is not mandatory, it must be the purpose. If you are in this situation, it is definitely worth the investment to consult your tax advisor and determine whether you are doing what’s necessary to avoid classification as a hobby.

By Tania Sederdahl, CPA
Bland Garvey, P.C.
2600 N. Central Expy.
Suite 550
Richardson, TX 75080

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