Many years back a friend and I from another tax firm were avid sports card collectors, and one day while at a show we decided to buy out all the inventory of one of the dealers on a whim. We turned around and sold off most of the newer cards that were popular with collectors at the time for half-off, and we kept all the older cards this dealer had on his table. We decided at the time this was an efficient way to acquire the older vintage cards at a significant discount. So, we decided to go in to the business of selling cards. We acquired the necessary sales tax permit and DBA certificate and hit the show circuit. I was new to taxes at the time, but I did know a little bit about the hobby loss rules, so at tax time, we had a decision to make. Were we a for profit business or a hobby for tax purposes? More on the outcome of this discussion at the end of the post.
Why does it matter if your business is a hobby?
If you do not carry on your business to make a profit, there is a limit on the deductions you can take. You cannot use a loss from the activity to offset other income. Activities you do as a hobby, or mainly for sport or recreation, come under this limit. It is important to understand that there generally must be some prospect for a profit.
Hobby income and expenses are treated differently than business income and expenses. Prior to 2018, taxpayers who participated in an activity deemed a hobby reported their income as other income on Form 1040 while claiming their deductions as a miscellaneous itemized deduction subject to a 2% of AGI limit. Taxpayers who were unable to itemize had no chance for a deduction of hobby expenses, and those who could itemize lost some or all of their deductions to the 2% limitation.
The Tax Cuts and Jobs Act of 2017 (TCJA) eliminated 2% miscellaneous itemized deductions from Schedule A. Therefore, beginning in 2018, taxpayers who participate in hobby activities are required to report all the earnings as other income on the Form 1040 while receiving no benefit of their deductions. This is a tough place to be if your hobby activity generates a meaningful amount of income. The good news is that hobby income is not subject to self-employment tax.
How do you determine if your activity is a business or hobby?
In making the distinction between a hobby or business activity, take into account all facts and circumstances with respect to the activity. A hobby activity is done mainly for recreation or pleasure. No one factor alone is decisive. You must generally consider these factors in determining whether an activity is a business engaged in making a profit:
- Do you carry on the activity in a businesslike manner and maintain complete and accurate books and records? A business will maintain a separate checking account, save receipts, maintain a bookkeeping system, and prepare financial reports.
- Does the time and effort you put into the activity indicate you intend to make it profitable? Someone operating a business will engage in the activity with continuity and regularity. This does not mean everyday. It just means that you must have consistent business activity.
- Do you depend on income from the activity for your livelihood? This is an area that can trip up some hobby businesses. One factor that will be considered is whether you have adequate income from other sources that does not necessitate the need for the potential hobby business activity to make a profit. A common example of a hobby activity is the weekend rancher where someone has adequate income to sustain their lifestyle, and they run a few cows on some land they own.
- Are your losses are due to circumstances beyond your control (or are they normal in the startup phase of your type of business)? Many business do not show a profit in the early years for legitimate business reasons. For example, a restaurant may take some time to gain a following or a new online store might take some time to attract customers. A loss does not mean your business is a hobby.
- Have you changed your methods of operation in an attempt to improve profitability? This is a critical factor (in the author's opinion). A business owner will make adjustments to try and salvage a profit. For example, let's say you enjoy woodworking and decide to sell some of your work to make some extra income. You find that demand is not quite what you expected, so you go to some local furniture retailers to determine what customers are buying. You then buy a couple of new items of equipment and modify your inventory to better match your products with market demand. This type of change is very much in line with someone who is operating a business for profit.
- Do you or your advisors have the knowledge needed to carry on the activity as a successful business? Let's revisit the weekend rancher example. If you have never operated a small ranch or you do not hire someone that knows how to manage a ranch, it may indicate that you lack a profit motive.
- Were you were successful in making a profit in similar activities in the past? If the answer here is yes, then it might indicate reasonable potential for a turnaround.
- Does the activity makes a profit in some years and how much profit it makes? Occasional profits are important, and just another reminder that a loss in and of itself does not mean that your business is a hobby.
- Can expect to make a future profit from the appreciation of the assets used in the activity? This is a tricky area to apply, and it most often comes in to play for weekend rancher or horse breeder. If the land was acquired to operate a ranch, then the appreciation of the land is clearly associated with the business activity of ranching. However, if the land was bought for appreciation, and then you decided to raise some livestock, then it may or may not come in to play depending on the profitability of the business activity.
None of the above nine factors can stand on their own to disprove or prove an activity is a trade or business as compared to a hobby. You must consider the analysis of each factor as a whole, and then make a determination. It is important to remember that for a business to exist, there must be some continuity of activity, you must be engaged in the business regularly, and you must have a profit motive.
Profits help avoid a potential hobby determination
An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least 2 of the last 7 tax years, including the current year. The activity must be substantially the same for each year within this period. You have a profit when the gross income from an activity exceeds the deductions.
Limited Relief from the IRS for hobby determination
If you are starting an activity and do not have 3 (or 2) years showing a profit, you can elect to have the presumption made after you have the 5 (or 7) years of experience allowed by the test. You can elect to do this by filing Form 5213. Filing this form postpones any determination that your activity is not carried on for profit until 5 (or 7) years have passed since you started the activity.
The benefit gained by making this election is that the IRS will not immediately question the business status of your activity. The disadvantage of Filing Form 5213 is it automatically extends the period of limitations on any year in the 5-year (or 7-year) period to 2 years after the due date of the tax return for the last year of the period. The period is extended only for deductions of the activity and any related deductions that might be affected. However, if you are involved in a business activity that will take time to show profits, and you expect profits in the future, then Form 5213 is worth consideration.
And back to the sports card business....
The sports card business lasted about two years before we got too busy working and the sports card fad of the early 1990's began to fade. We were lucky enough to show profits for each of the two years, and we kept good business records, a separate checking account, and regularly attended shows in Lubbock and all around the Texas pandhandle.
Have a question about your business activity, give us a call.