Hobby Rules May Limit Claimable Losses from Sideline Businesses
The best tax shelter is owning and operating a business. Not only can losses and deductions be claimed against marginal income tax, but also against self-employment taxes for which there are few other deductions of any kind. Because of the substantial tax savings, many people try to claim the expenses of a hobby as business expenses. To prevent this, the IRS disallows any losses claimed on a hobby to offset any other type of income, including other business income. Losses can only be offset by income earned from the hobby itself. Previous to the 2017 Tax Cuts and Jobs Act (TCJA), the income from a hobby was claimable on Form 1040 as other income, claimed by filing Schedule A, Itemized Deductions where the deduction was limited by the 2% adjusted gross income floor for miscellaneous itemized deductions, but the 2017 TCJA eliminated this deduction. If the profit results from the sale of a hobby collection, such as coins or stamps, then any profit is taxed as a capital gain, but losses are not deductible, since they are considered personal losses. Furthermore, the deductions on Schedule A can only be taken after deducting those expenses that can be claimed regardless of whether the hobby is a business or not, such as mortgage interest and state and local taxes. However, these deductions will lower the amount of income that can be used to offset the expenses of the activity.
What, then, distinguishes a hobby from a business? A person conducts a business to earn a profit, while a hobby is pursued because it is pleasurable. Hence, the primary distinguishing characteristic between a business and a hobby is the profit motive. Is the business being conducted to maximize profit?
When a business is pursued for profit, the business owner seeks to maximize income while minimizing expenses, because, although expenses are tax deductible, the taxpayer only saves the effective tax rate on the income — not the whole amount. However, if an activity is pursued primarily for the pleasure, then income is not the primary concern, so the taxpayer is less concerned about the amount of the expense in relation to the income that it produces.
Over the years, the IRS and the courts have developed a set a rules to help differentiate between a business and a hobby:
- the time and effort spent in the activity;
- the taxpayer's expertise in the activity;
- how the activity is carried out;
- the history of income and loss from the activity;
- the percentage of the taxpayer's income that comes from the activity;
- is it an activity that others frequently pursue just for pleasure;
- the marginal profit benefit of a deduction compared to the amount of the deduction;
- the success with which the taxpayer has had in other businesses;
- losses in the early years are common in the activity;
- the completeness of business records;
- did the taxpayer have a written business plan for achieving profit;
- did the taxpayer rely on expert advice; and
- is there any potential that profit may arise from the appreciation of the business property.
The history of profitability in the activity is applicable to several additional tax rules. Generally, if the taxpayer earns a profit in 3 out of any 5 years, then a profit motive is presumed. If the activity fails the 3-out-of-5 rule in its 1st 5 years, then the taxpayer may ask the IRS to defer judgment on whether it is a business or a hobby until after the 4thtaxable year after the activity was started, by filing Form 5213, Election to Postpone Determination As to Whether the Presumption Applies That an Activity Is Engaged in for Profit. Horse breeders, evidently, have a more successful lobby to influence Congress, since they only have to show a profit in 2 out of 7 years; this rule also applies to horse training, showing, and racing activities. They can also request that the IRS defer judgment on whether the horse activity is a sideline business or a hobby until after the 6th taxable year of the activity by filing Form 5213. However, by filing Form 5213, the taxpayer agrees to extend the statute of limitations for all items related to the activity during the applicable period, thus, giving the IRS 2 additional years beyond the last year of the applicable period to issue any deficiencies during the entire period covered by Form 5213. Form 5213 must be filed within 3 years after the due date for the tax year covering the inception of the activity. If the IRS issues a deficiency notice before the 3-year period, then Form 5213 must be filed within 60 days of receiving the notice. Individuals, estates, trusts, partnerships, and S corporations can make the selection, and if a partnership or S corporation does so, then the election is binding on all partners or shareholders that held an interest in the activity during the presumption period.
Even if a profit is earned in 3 out of 5 years, the IRS may try to rebut the profit-motive presumption, and if it successively does so, then the burden of evidence will fall on the taxpayer to show otherwise. However, even if the activity earns no profit for many years, expenses may still be deductible if there is sufficient evidence that the activity is being pursued for a profit, but the burden will be on the taxpayer to prove that there is a realistic expectation of profit.