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Hobbies May Be Serious Business in the Eyes of the IRS

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Jul 6th 2015
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A couple I'll call “Ceil and Carl” asked for my advice. He works for a company struggling to survive. She's a science teacher for a budget-strapped school system that plans to increase class sizes and fire many instructors.

To cope with these times of high job insecurity and streamlined workplaces, Ceil and Carl have come up with creative ways to supplement their salaries. They both moonlight nights and weekends as freelance writers. He's the author of several books for children. She does science articles for newspapers, magazines, and websites.

Ceil characterizes their moonlighting as “small hobby businesses that bring in only pocket money at present,” though they hope to step up the pace of activity and become full-time writers within several years. Like lots of others writers who contact me, they're clueless about how and why the IRS distinguishes between “businesses” and “hobbies.” I explained that the law allows them to offset business losses they incur in the early years of their part-time, sideline ventures against their salaries from full-time jobs and other sources of income. Their failure to deduct such losses means they've paid more taxes than legally required, the same as many other freelancers.

I told the couple to dust off their copy of the Internal Revenue Code and bone up on Code Section 183. It allows deductions for losses suffered in transactions entered into to make “profits” and denies them for losses incurred to pursue hobbies (except to the extent of any income derived from the activity in question). So the IRS routinely scrutinizes returns that reveal full-time salaries and other kinds of income offset by losses from sideline undertakings that prove to be hobbies – writing, photography, and painting, to cite some of the activities that are likely to draw the agency's attention.

Understandably, Ceil and Carl want to know just how the IRS goes about determining whether they are hobbyists or their intention is to realize business profits. I can't refer them to any all-purpose guidelines. The answer depends upon the particular circumstances.

To illustrate, a string of yearly losses usually indicates that an individual's enterprise is nothing more than a hobby. However, bad luck isn't necessarily fatal.

The IRS got exactly nowhere when it told the Tax Court to throw out losses sustained by Gloria Churchman, a painter who operated in the red for 20 – count 'em, 20 – consecutive years. The court cited evidence showing that Gloria acted in a businesslike manner.

What I'm able to say is that the law allows writers to take advantage of something known in tax jargon as a “presumption of profit.” Section 183 presumes that you're engaging in a business (not a hobby) with the IRS as your partner if you have a net profit in any three out of the last five consecutive years (two out of seven years for someone involved in the breeding, training, showing, or racing of horses). But that presumption can be rebutted by the IRS.

Consequently, there's usually no need to be concerned when you've at least three profitable years during the last four. A passing grade on that test entitles you to fully deduct your expenses for this year, even if it proves to be a loss year.

All is not lost if you splash red ink in more than two out of five years. An often-misunderstood relief provision is that failing the three-out-of-five stipulation isn't fatal, provided you're able to establish that you conduct operations in a businesslike fashion, as did Gloria, who, remember, never showed a profit.

About the author:
Julian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator) and an attorney. More on this topic is available from “Julian Block's Year Round Tax Strategies,” available at julianblocktaxexpert.com.

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