Do you take photographs, sew, sell crafts, collect stamps or coins, garden, fish, bowl, build models, sell consumer products under a network marketing arrangement? Do you receive income from any of these activities?
Under the Internal Revenue Code, you must pay tax on *all* your income. However, the Code treats business income differently from hobby income – or in current IRS parlance “Activities Not Engaged in for Profit.”
If you are engaged in a business with the intention and reasonable expectation of earning a profit, then your ordinary, necessary and reasonable business expenses are deductible.
A hobby is defined as an activity that is not pursued for profit, but for personal pleasure. Losses on hobbies cannot be used to offset other sources of income. Instead of being deducted directly against your income, your expenses are limited to the amount of gross income, and allowed only as itemized deductions subject to the 2% AGI “haircut.” Yes, if you take the standard deduction and don’t itemize your taxes, mortgage interest, charity and the like, then you also can’t deduct the expenses of your income-earning hobby.
The justification for this treatment is that money-losing hobbies, if treated as businesses, offset your primary income sources, giving you a “tax shelter” in your leisure activities – but not a legal one.
As you can see, it’s critical to understand whether you are conducting a business or a hobby, and to be prepared to support your determination if challenged by IRS.
- Do you have the knowledge to succeed?
- Do expended time & effort support your “intention” to make a profit?
- Do you depend on income from the activity?
- Do you run the activity in a business-like fashion? Do you tightly control expenses?
- Have you made profits in the past, in this or similar activities? Does the activity make a profit some years?
- Do you analyze your operations & make changes to improve profitability?
- Have losses been beyond your control, or limited to the start-up phase?
The IRS presumption is that a business should earn income in three out of five years. Given a two-year start-up loss period, the third year should be a turning point. Should you stay in business? Or are you really in business?
IRS is cracking down on “Activities Not Engaged in for Profit.” The “Tax Gap,” estimated to be over a half a trillion dollars a year is in part due to unreported income or incorrect application of (complex) IRS rules.
This is a complex and hazardous area; IRS penalties can be severe. Do your research in Internal Revenue Code §183, IRS Publication 535 and recent pronouncements, or consult a professional. 1TaxFinancial offers a free consultation to discuss your situation.