Do you have a client who is an expert at molding pottery or chartering fishing trips? An activity that starts out as hobby can turn into a full-fledged business over time if people are willing to pay for the goods or services a taxpayer can offer. But clients might not be aware of the tax distinctions between a "hobby" and a "business." If you instruct them on how to best handle things, they can realize some key tax benefits along the way.
Here's a quick review: Generally, a taxpayer must report income from a hobby on his or her personal tax return, but can deduct expenses relating to the activity. However, the deductions can't exceed the amount of income from the hobby. Conversely, if the activity is treated as a business, there's no such restriction. Thus, the taxpayer can effectively claim a loss that may offset other highly taxed income.
Because this is a gray area, the IRS often challenges losses from borderline activities. According to a recent fact sheet (FS 2008-23), it will focus on the following factors in determining whether an activity is a hobby or business.
- Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from the activity?
- If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
As you might imagine, this matter frequently ends up in the courts. But at least taxpayers have a presumption on their side: If you show a profit in three out of five consecutive years, the activity is presumed to not be a hobby. Of course, the IRS can still rebut this presumption with convincing evidence, but it does give taxpayers a leg up. For horsing enthusiasts looking to train the next California Chrome, the presumption applies if you show a profit in only two of seven consecutive years for an activity involving breeding, training, showing or racing of horses.
How can clients safeguard hobby loss deductions? Once it's clear that you expect to treat the activity as a business, run it just like you would any other business. That means keeping detailed records, using a separate bank account for the business and meeting all the other technical requirements, such as obtaining the right licensing and paying any special taxes or fees. This is the best proof you can have if the IRS ever contests a loss deduction.
Those who want further details can find them in a recent Journal of Accountancy article.