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Over the next 10 weeks I want to share some basic tax tips that can be used for year end planning or thinking about your taxes for next year.
Review All Articles in This Series: 10 Tax Tips
TAX TIP NUMBER 9: BUSINESS OR HOBBY?
This question comes up often when it comes to taxpayers who have 2 or sometimes 3 activities some of which are making money and some of which are not. The concern is that how can a person run 2 or 3 business and intend to make money. If a business is not considered a business then it can be treated by the IRS as a hobby. As a hobby, whatever expenses are incurred can only be deducted up to the amount of income and not beyond. As such, if there is a loss in what will be characterized as a hobby then the losses in that hobby cannot be used to offset income from other activities. Therefore, the importance of whether an activity is a hobby or business can make a big difference.
In the tax law a trade or business is defined as a regular activity engaged in with a profit motive. A hobby is defined as an activity not engaged in for profit. These seemingly simple definitions have spawned enormous amount of regulations and case law.
Some of the rules and principles relating to whether an activity is a trade or business or a hobby are summarized below.
If an activity actually makes a profit 3 out of 5 years, then the presumption that is was a hobby will not apply. For breeding and training it is 2 out of 7 years. This means that if you operate what you want to be a business for 5 years and you have a profit in three of these years, then the other two years you can have losses that can offset other income. While you may think this could be easy, i.e. just show 1 dollar of profit, it isn’t quite that simple. The amount of profit in relation to losses, the taxpayers investment and the value of the assets used in the activity may all have a bearing on whether there was an intent to make a profit.
We all know the classic Mary Kay home based business used for the purpose of receiving office in the home deductions and losses. This is a classic business versus hobby conflict. Here is a short description of where losses were disallowed for Amway distributors.
Thus, an Amway distributor did not establish a profit motive where he made only three sales in the year in issue with a gross profit of $41, although he held numerous social events to recruit friends, relatives, and acquaintances to the Amway system for which he claimed $32,432 in business expense deductions. 15 Similarly, another Amway distributor failed to establish a profit motive for the one year at issue where gross profit was $627, additional bonuses of $1,516 were received from Amway, but expenses were $15,781. 15.1
Here are some other factors that go into the consideration of whether there is an intent to make a profit.
(1) manner in which taxpayer conducts the activity;
(2) expertise of taxpayer or his advisers ;
(3) time and effort taxpayer spends on the activity ;
(4) expectation that assets used in activity may appreciate in value ;
(5) taxpayer’s success in similar or dissimilar activities;
(6) taxpayer’s history of income or losses with respect to the activity;
(7) the amount of profits;
(8) taxpayer’s finances; and
(9) elements of personal pleasure or recreation.
Here is where most people get into trouble. They are a full time employee receiving a paycheck and then they have what they call a side business. The problem is in substantiating the number of hours spent on the business, networking, business cards, performing the services, accounting and the like. I am not suggesting that this can’t be done as there are people who run side businesses after work and on week-ends, however there is only so much time in a day. Showing how profit will be generated when working a full time job may be difficult. Coming back to the Mary Kay example, leveraging the downstream people to generate business and revenue is an example of how a person may show they have a business in addition to other work.
The point of this blog and the ones on mileage and charitable deductions hopefully is to point out that the rules are very complex, with many exceptions, nuances and traps. There are opportunities to take advantage of the tax laws and having the right advice is critical. As I stated in my last blog I am trained as a tax attorney. That means I have the legal experience and I have highly specialized tax training as well. This means that when there is a tax question, I have the full understanding of the legal nuances, hidden meanings, rulings and interpretations of the case law. It’s not enough just to hope and pray the IRS won’t exam your return. It’s what I can advocate on your behalf and prove.
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