Dec 7th 2010
By Gil Charney, CPA, CFP, MBA
This is the first of two articles about expenses incurred by clients who are engaged in an activity, and whether such activity can be considered a business or a hobby. In the first article, the scenario of a freelance writer is used to discuss the business vs. hobby issue.
Taxpayers whose expenses are considered hobby expenses may not claim a loss from that activity, although they may deduct the expenses against income from that hobby. Conversely, business expenses may be deducted fully from business income, generate a loss, and offset the taxpayer’s ordinary income. These differences, among several others, require that the tax preparer have a clear understanding of all the facts and circumstances to determine whether a client’s activity is a trade or business, or a hobby.
The second article will explore the deductibility of certain expenses that are commonly presented by taxpayers as business expenses, such as travel, special clothing, and research expenses. Even after the tax preparer is confident about the classification of a client’s activity, the deductibility of certain expenses may be difficult for the tax preparer to determine without understanding the facts and circumstances surrounding the expense.
A client conversation
John Keats, your new client, shows up for his first appointment carrying a ream of papers, receipts, and last year’s tax return (prepared by his brother-in-law, a physical therapist). John is getting more work for his freelance writing business, and he believes he should have a professional tax preparer complete and file his tax return.
After an introductory conversation with John and a quick review of his documents, you learn that John works full-time as a public relations professional at a large corporation. He earned a salary of $83,000 in 2009.
You notice an entry for $800 on Form 1040, Line 21. John explained that the income was for writing an article that was purchased by a local magazine publisher. The publisher loved the article and encouraged John to submit more work. John wanted to do more freelance writing for the extra money, as well as a possible new career if his corporate employer continued with its downsizing. John’s article was a travel article about bicycling in California.
You asked John whether he had any other income from his freelancing activities, which he did not. He replied that his brother-in-law didn’t even want to report the freelancing income at all because John was not a professional writer. However, John thought it should be reported, but he allowed his brother-in-law to record it on the other income line because, according to John, “That’s what it was – other income.” You also asked about expenses that might have gone along with the freelance income. John thought for a moment and then replied he didn’t think he had any in 2009, when he wrote his article.
Encouraged by this quick success and the publisher’s encouragement, John submitted more articles in 2010, as well as to other publishers with larger circulation. Several of his submissions were accepted, and for 2010, John earned $14,500 for his freelance work in addition to his full-time corporate salary.
In 2010, John described several expenses that he incurred related to his freelance writing, such as membership fees to a bicycle club, bicycling trips to Colorado and other locations, and a new computer. He also bought a new bike ($6,500) because it was related to his freelancing activity and would allow him to write articles (and maybe a book!) about his bicycling experiences, while earning income.
As you converse with John and thumb through his papers, a number of questions begin to pop up in your mind. Is John’s writing activity a business or a hobby? What deductions, if any, can he claim against that income? If an expense is partially deductible, to what extent is it deductible, and what documentation is required to support the deductible component?
Business or hobby?
Taxpayers who are wage earners or sole proprietors – or both – may incur expenses that might be related to their employment or business. The Internal Revenue Code states, “There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business…”1 In a nutshell, a tax preparer must evaluate whether an expense was incurred in a “trade or business,” and whether it was an “ordinary and necessary” expense for that business. Only by considering all the facts and circumstances can a tax preparer make such a determination.
Before you can determine (1) whether John’s expenses may be deducted, (2) to what extent they can be deducted, and (3) how to report them on his tax return, you will first need to determine whether his freelancing activity is a business or a hobby. For tax purposes, a hobby is an as activity that is “not engaged in for profit.”2
After you determine that John’s activity is a business or a hobby, you will be better prepared to evaluate the deductibility of his expenses and where to report them.
The implications for the client can be significant. In general, if you determine that John’s activity is a hobby (i.e., he does not engage in it for profit), his expenses are restricted in at least four ways:
(1) They are limited to hobby income. According to IRC Sec. 183(b)(2), deductions that are allowable may be deducted “to the extent that the gross income derived from such activity for the taxable year exceeds the deductions allowable . . .” In other words, a loss from hobby income cannot be used to offset ordinary income.
(2) Hobby expenses are reported as itemized deductions on Schedule A. Unlike a deduction that qualifies as a business expense, hobby expenses are deductions from AGI, rather than for AGI (as they would be as business deductions on Schedule C). Thus, not only is John’s AGI increased by his hobby income, but his AGI cannot be reduced dollar-for-dollar by his hobby expenses. Moreover, the hobby income may increase his AGI to a level that disqualifies him from claiming certain tax benefits, or reduces such benefits due to phase-outs.
(3) The hobby expenses reported on Schedule A, but they are considered miscellaneous itemized deductions subject to the 2 percent-of-AGI limit (which, of course, is now higher because of his hobby income). As if this weren’t enough, miscellaneous itemized deductions are preference items for the alternative minimum tax. Therefore, if his hobby expenses are high enough, the miscellaneous deduction could trigger (or increase) his AMT income (AMTI).
(4) Unlike suspended losses for passive activity income, hobby losses may not be carried forward to a year in which hobby income is high enough to absorb such losses. Any unused expenses for the year are permanently lost.
If you determine that Keats’ activity is a hobby, you will report his income on Form 1040 Line 21, rather than on Schedule C. The silver lining here is that such income is not subject to self-employment tax.
Classifying John’s activity as a business offers distinct advantages by allowing deductions to offset his related income, possibly generate a net operating loss, and reduce his AGI (and possibly his AMTI).
However, as an ethical tax preparer, you must first ascertain all the facts and circumstances to conclude whether his activity can be classified as a business. Your due diligence in this matter involves asking relevant questions of Keats, documenting his responses, and clarifying inconsistencies and other facts that you may be aware of or learn from his prior responses. There is no hobby loss due diligence form comparable to the EITC due diligence Form 8867 (Paid Preparer’s Earned Income Credit Checklist).
Fortunately, the regulations do offer guidance in determining whether an activity is a business or a hobby. Reg. Sec. 1.183-2(b) offers nine factors, including examples, a tax preparer may use to make such a determination.3 It is important to note that these factors, which may be well known to tax preparers, do not constitute an exhaustive checklist. Satisfying five out of nine factors does not automatically allow the taxpayer to pass the test of whether the activity is a for-profit business.
Moreover, none of the factors dominate; there is no litmus test that automatically qualifies an activity as a business or a hobby. The regulation states, “The determination whether an activity is engaged in for profit is to be made by reference to objective standards, taking into account all of the facts and circumstances of each case.”4 The nine factors of Reg. Sec. 1.183-2(b)(1)–(9) are presented in their entirety in this article for reference in evaluating John’s situation. The factors are:
“(1) The manner in which the taxpayer carries on the activity.5 The fact that the taxpayer carries on the activity in a businesslike manner and maintains complete and accurate books and records may indicate that the activity is engaged in for profit. Similarly, where an activity is carried on in a manner substantially similar to other activities of the same nature which are profitable, a profit motive may be indicated. A change of operating methods, adoption of new techniques, or abandonment of unprofitable methods in a manner consistent with an intent to improve profitability may also indicate a profit motive.”
For example, taking a position that his freelancing activity is intended as a business is more supportable if John keeps distinct records and a separate checking account for his freelancing activity. However, as noted above, this by itself is not determinative that his freelancing activity is a business – even if he uses a “doing business as (DBA)” on the checking account.
“(2) The expertise of the taxpayer or his advisors. Preparation for the activity by extensive study of its accepted business, economic, and scientific practices, or consultation with those who are expert therein, may indicate that the taxpayer has a profit motive where the taxpayer carries on the activity in accordance with such practices. Where a taxpayer has such preparation or procures such expert advice, but does not carry on the activity in accordance with such practices, a lack of intent to derive profit may be indicated unless it appears that the taxpayer is attempting to develop new or superior techniques which may result in profits from the activity.”
Because Keats has already published several articles, he has demonstrated the necessary and appropriate skill as a writer. If he engaged in an activity in which he had little skill or knowledge, his ability to generate income would be impaired, thus making the case for a business less plausible.
However, taxpayers who start a business without the necessary knowledge or skill, or without any credible advisors assisting them, may be setting themselves up for failure – but they may still have a profit motive.
“(3) The time and effort expended by the taxpayer in carrying on the activity. The fact that the taxpayer devotes much of his personal time and effort to carrying on an activity, particularly if the activity does not have substantial personal or recreational aspects, may indicate an intention to derive a profit. A taxpayer’s withdrawal from another occupation to devote most of his energies to the activity may also be evidence that the activity is engaged in for profit. The fact that the taxpayer devotes a limited amount of time to an activity does not necessarily indicate a lack of profit motive where the taxpayer employs competent and qualified persons to carry on such activity.”
Asking Keats how much time he spends writing will be an important question. As a full-time corporate, professional employee, his primary business activity requires his attention for at least forty hours per week. Although his activity as an employee may restrict the available time to work a side business, the amount of time he spends researching, writing, editing, and communicating with publishers could be substantial and should influence your decision. If he can produce a journal of time spent, correspondence or e-mails with publishers, and other supportive documentation, he not only will strengthen his position with respect to this factor, but also the first factor (the manner in which he carries on the activity).
However, remember that in your initial meeting with John, he confessed that he was looking for some extra spending money and a possible new career in case he should be laid off from his corporate job. These are telling statements about his profit motive. However, you decide not to jump to conclusions and to evaluate all the facts and circumstances (you know all too well that statements from clients cannot always be relied upon!).
“(4) Expectation that assets used in activity may appreciate in value. The term “profit” encompasses appreciation in the value of assets, such as land, used in the activity. Thus, the taxpayer may intend to derive a profit from the operation of the activity, and may also intend that, even if no profit from current operations is derived, an overall profit will result when appreciation in the value of land used in the activity is realized since income from the activity together with the appreciation of land will exceed expenses of operation.”
This factor does not relate to Keats’ activity as a freelance writer. Again, not each factor may be present, and some facts and circumstances may apply to more than one factor.
“(5) The success of the taxpayer in carrying on other similar or dissimilar activities. The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he is engaged in the present activity for profit, even though the activity is presently unprofitable.
(6) The taxpayer’s history of income or losses with respect to the activity. A series of losses during the initial or start-up stage of an activity may not necessarily be an indication that the activity is not engaged in for profit. However, where losses continue to be sustained beyond the period which customarily is necessary to bring the operation to profitable status, such continued losses, if not explainable, as due to customary business risks or reverses, may be indicative that the activity is not being engaged in for profit. If losses are sustained because of unforeseen or fortuitous circumstances which are beyond the control of the taxpayer, such as drought, disease, fire, theft, weather damages, other involuntary conversions, or depressed market conditions, such losses would not be an indication that the activity is not engaged in for profit. A series of years in which net income was realized would of course be strong evidence that the activity is engaged in for profit.”
Both Factors 5 and 6 relate to a proven track record in conducting a business of the same or similar type as the current activity and the taxpayer’s ability to turn a profit. These also indirectly reflect the taxpayer’s expertise (See Factor 2), in that to be consistently profitable at an activity a taxpayer must have the necessary skills and ability. Keats’ early forays into freelance writing have been successful and demonstrate expertise, if not a track record.
However, having expertise and early success is not necessarily an indication the taxpayer has the intent to create a profit.
“(7) The amount of occasional profits, if any, which are earned. The amount of profits in relation to the amount of losses incurred, and in relation to the amount of the taxpayer’s investment and the value of the assets used in the activity, may provide useful criteria in determining the taxpayer’s intent. An occasional small profit from an activity generating large losses, or from an activity in which the taxpayer has made a large investment, would not generally be determinative that the activity is engaged in for profit. However, substantial profit, though only occasional, would generally be indicative that an activity is engaged in for profit, where the investment or losses are comparatively small. Moreover, an opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit even though losses or only occasional small profits are actually generated.”
The IRS allows a presumption for profit in activities that are occasionally profitable. Needless to say, not every business earns a profit every year, made even more difficult by these economic times. Thus, the lack of profit does not nullify a taxpayer’s intent to create a profit. In general, IRS grants that a taxpayer who has earned a profit in an activity for at least three of the previous five years is presumed to have a profit motive.
In Keats’s case, with no prior history selling his work, the presumption for profit does not exist under this safe harbor guideline. If he continues to sell his work profitably, he may be presumed to be conducting a business.
If Keats strongly believes he is conducting business, and after you have evaluated the facts and circumstances you agree with him, he may avoid an inquiry by IRS for five years as to whether the activity is a business by filing Form 5213 (Election to Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit).
When the taxpayer files this form, the IRS will not challenge the taxpayer’s position that the activity is a business, and all related expenses may be deducted as if they were business expenses. However, if the taxpayer fails to demonstrate a business activity after this period, any prior loss will be disallowed and the hobby loss rules under IRC Sec. 183 will be applied, possibly subjecting the taxpayer to penalties under IRC Sec. 6662 (accuracy-related penalties).
Note that if John abandons his activity as a freelance writer, amending prior year returns when business deductions were claimed for the activity may not be required if you can demonstrate that a reasonable position was taken for his deductions as business deductions. In other words, he may have been engaged in a profit-making activity but decided later to discontinue the activity.
Doing so does not disqualify the activity as a business. Indeed, Keats might argue logically that when he saw he could not make a profit, he decided to abandon the business. Once again, you will need to evaluate all the facts and circumstances surrounding this decision.
If you determined that Keats did not have a profit motive when he began his freelancing activity in 2009, but then adopted a desire to earn a profit in 2010, he cannot amend his 2009 return to convert his hobby expenses into business expenses. However, the activity can vary between profit-seeking and not profit-seeking in different years. As noted in Ranciato,6 “In order to escape the grasp of Sec. 183 [hobby loss rules], it is not enough to have a profit intent before the years in dispute. The taxpayer must possess the required intent during the years in dispute.”
“(8) The financial status of the taxpayer. The fact that the taxpayer does not have substantial income or capital from sources other than the activity may indicate an activity is engaged in for profit. Substantial income from sources other than the activity (particularly if the losses from the activity generate substantial tax benefits) may indicate the activity is not engaged in for profit especially if there are personal or recreational elements involved.”
As the regulation suggests, if the activity is the taxpayer’s only source of income, there is greater probability the taxpayer has a profit motive in undertaking the activity. Because Keats is a full-time employee earning a decent salary, he may not need the income generated from the freelancing activity to support himself, and therefore the motive to earn a profit is diminished.
However, the existence of a salary or other sources of income does not preclude an activity from being undertaken for a profit, as any employee with a successful side business can attest. John may want to supplement his income with earnings from his freelancing business, and undertakes the activity purely with a profit motive. Indeed, he has told you he wants to earn extra money. Does that constitute a profit motive?
“(9) Elements of personal pleasure or recreation.7 The presence of personal motives in carrying on of an activity may indicate the activity is not engaged in for profit, especially where there are recreational or personal elements involved. On the other hand, a profit motivation may be indicated where an activity lacks any appeal other than profit. It is not, however, necessary that an activity be engaged in with the exclusive intention of deriving a profit or with the intention of maximizing profits. For example, the availability of other investments which would yield a higher return, or which would be more likely to be profitable, is not evidence that an activity is not engaged in for profit. An activity will not be treated as not engaged in for profit merely because the taxpayer has purposes or motivations other than solely to make a profit. Also, the fact that the taxpayer derives personal pleasure from engaging in the activity is not sufficient to cause the activity to be classified as not engaged in for profit if the activity is in fact engaged in for profit as evidenced by other factors whether or not listed in this paragraph.”
The concept of mixing business with pleasure suggests they are separate and implies that a business activity is distinct from a pleasurable activity. Tax preparers should be familiar with this concept when determining whether a trip is taken “primarily” for business – vacations are not deductible even if some business is transacted. If a taxpayer has a horrible vacation, he still may not deduct the expenses! However, even trips that are enjoyable can be partially deductible if the primary reason for the trip was business.
That said, the element of pleasure in an activity, as the reg. notes, may indicate the activity is not engaged in for profit. Taxpayers who breed and race horses, or buy and race fast cars, or carry on other expensive activities may try to write off their hobbies, and a tax preparer must pay careful attention to such situations.8
In the case of Keats, writing is not an activity that one typically identifies as recreational or pleasurable. However, the bicycling trips he takes to write about could cross this line. As John’s tax preparer, you will need to determine if his journalistic activities are covers for his exotic trips or if he is taking the trips as material for which to write articles – even if he enjoys the trips. Only by examining all the facts and circumstances can you reach a level of confidence regarding such travel.
After evaluating all the facts and circumstances, including John’s responses to your questions (all of which you have documented) about his time spent on the activity, his motive, and the level of his earnings, and applying the factors in Reg. Sec. 1.183-2(b), you believe a position for claiming business income and deductions for this activity is warranted for 2010, although not for 2009.
You also recalled Keats’ comments that he wanted to earn extra money and prepare for a possible layoff from his corporate job. You decide that although this does not sound like a strong profit motive on the surface, earning extra money does involve a profit motive, while embarking on a possible new career after a possible layoff is also a profit motive. Earnings from freelancing would replace taxable wages earned as an employee.
Expenses incurred for the production of an activity’s income may be deductible, regardless of whether the activity is a business or a hobby (“activity not engaged in for profit”). However, the classification of the activity as a business or hobby will affect the extent of the activity’s deductions and tax reporting. The tax preparer is obligated to seek out all the facts and circumstances regarding the client’s business activities, document such findings, and report the related income and expenses appropriately based on the conclusion. EA
About the Author:
Gil Charney, CPA, CFP, MBA, is a principal tax analyst at The Tax Institute at H&R Block, where he conducts research into complex tax problems and analyzes tax legislation. He also leads a team of EAs, CPAs, and tax attorneys in maintaining The Tax Institute’s Tax Research Center. He has extensive experience in consulting, research, and corporate financial management. He also has taught graduate-level courses in accounting and finance and directed H&R Block’s tax training department.
1 IRC §162(a)
1 IRC §162(a)
2 IRC §183(c)
3 These factors are described also on the IRS Web site and IRS Pub. 535 (Business Expenses)
4 Reg. Sec. 1.183-2(a)
5 Mahr, TC Memo 1982-297
Luce, TC Memo 1970-203
Morton, TC Memo 1971-156
6 Ranciato, TC Memo 1996-67
8 Underwood, TC Memo 1989-625; Ballich, TC Memo 1978-497