When the neighborhood kids set-up a lemonade stand on the corner, no one expects to see an IRS agent stop by for a drink, let alone on official business. Do the kids have to report the income from sales? Can they take a tax loss if their costs exceed their income? Should there be a different answer if the lemonade stand was open every day or was operated by adults rather than kids?
All income, from whatever source is taxable, even when kids sell lemonade and cookies. The question is not whether the income is taxable, but what the deduction side of the equation looks like. What may be deducted, where it is deducted and how much can be deducted is affected by whether the activity is a business or a hobby.
The proper classification is a big deal to the IRS. According to some estimates, the United States Treasury loses close to $30 billion in taxes due to Taxpayers incorrectly classifying hobbies as being businesses.
This article discusses the differences between businesses and hobbies. This includes how to distinguish between them as well as the basic differences in how they are treated for Federal Income Tax purposes.
Business or Hobby?
The Federal Income Tax laws, regulations, publications and court cases lay out the rules for determining whether an activity is a business or a hobby.
In general, the determination as to whether an activity is a business or a hobby is based upon the intent of the Taxpayer. That is, does the Taxpayer engage in the activity to make a profit or merely because they enjoy it? Sometimes, Taxpayers begin an activity because they enjoy it and, at some point, they change their intent and turn it into a business. The IRS cannot look within the souls of Taxpayers to determine their intent.
Accordingly, determining whether an activity is a business or a hobby is, for the most part, based upon the facts and circumstances of that particular Taxpayer, for that particular activity.
The IRS has created a set of guidelines to help determine whether an activity is a business or a hobby.
- Does the time and effort put into it reflect an intention to make a profit?
- Is the income from activity intended to financially support the Taxpayer?
- Have methods of operation changed in order to gain higher profits?
- Do the supervisors have the knowledge to continue the activity as a successful business?
- Is the activity similar to one that the Taxpayer has previously turned a profit on?
- If there are losses, do they result from circumstances beyond the Taxpayer’s control or in the start-up phase?
- Are profits made in some years?
- Are assets used in the activity expected to appreciate so as to make a profit in the future?
- Any activity that shows a profit in three of five years (including the then current year) is presumed to be carried on for a profit.
Running an Activity for Profit
In order to qualify for the tax benefits offered to businesses, a Taxpayer must be able to establish that they are involved in the activity to make a profit. Certain decisions and actions would be made differently where an activity is designed to make a profit.
For example, suppose an attorney who loves boats decided to build a boat. He spends $50,000 to build a new garage, buys $30,000 of new equipment imported from Germany and $10,000 of the finest woods. He does this knowing that he can only build 1 boat every year and that the most anyone would pay for the boat is $9,000. Clearly, the attorney is basing his decisions regarding his boat building activities on something other than intent to make a profit.
Let’s say that the same attorney decides to build boats, but takes a different approach than discussed above. He figures out that he could build 8 fiberglass boats each year in the same time that it would take to build 1 wood boat. The cost of materials is $2,000 per fiberglass boat and that he can sell them for $7,000 each. He buys $30,000 of equipment and parks his cars on the street so that he can use his existing garage for boat building. In this situation, there is clear evidence that the attorney is making his decisions based upon an intent to make a profit.
Qualifying for Deductions
Where an activity is classified as a business Taxpayers are entitled to deduct more types of expenses, in a more advantageous place on their Return and may even take a loss. Where an activity is classified as a hobby, deductions are limited in several different ways.
In order to be deductible, a business expense must be ordinary and necessary for the Taxpayers business. Business expenses can not only reduce the income from that business, but if there is a loss (i.e. business expenses exceed the income) that loss may be used to offset other income earned by that Taxpayer.
There are a variety of special rules and restrictions for expenses related to hobby activities.
- Deductions for hobby activities are claimed as itemized deductions on Schedule A (Form 1040). The type of Itemized Deduction is called a “Miscellaneous Itemized Deductions, Subject to a 2% floor”.
- If a Taxpayer does not have enough Itemized Deductions, they get no tax benefit for their valid hobby expenses.
- Itemized Deductions are deducted after the determination of Adjusted Gross Income (AGI). Since AGI is used to determine various tax limitations, the higher a Taxpayer’s AGI, the more limitations are imposed. AGI is also the starting point for determining a Taxpayer’s Illinois Income Tax which means that hobby deductions do nothing to reduce a Taxpayer’s state tax.
- A Miscellaneous Itemized Deduction Subject to a 2% Floor is a deduction category that limits deductions. No deductions for this category become an Itemized Deduction except to the extent that they exceed 2% of the Taxpayer’s AGI. For example, if a Taxpayer’s AGI is $100,000 and has $2,500 of deductions in this category, only $500 of the $2,500 goes on to become an Itemized Deduction ($100,000 x 2% = $2,000. $2,500 – $2,000 = $500).
- There is a special ordering rule for deducting types of hobby expenses that operate to reduce the tax benefit of such deductions.
Most Taxpayers are not familiar with the Federal Income Tax distinction between a business and a hobby. Through planning, a Taxpayer can increase his chances of having his activities classified as a business rather than as a hobby. If an activity is classified as a business the Taxpayer can get more and better deductions, resulting in a lower Federal and state Income Tax.
Copyright ©, Keith B. Baker – 2010
This article is designed to be a public resource of general information. It does not constitute “legal advice” nor does it create a “client-attorney” relationship. While the information is intended to be accurate, this cannot be guaranteed. Tax laws are complex and constantly changing as a result of new laws, regulations, court interpretations and IRS pronouncements. Often, there are also various possible interpretations. Further, the applicable rules can be affected by the facts and circumstances of a particular situation. Because of this, some of the information may no longer be correct or may not apply to all situations. We are not responsible for any consequences or losses resulting from your reliance on such information. You are urged to consult an experienced lawyer concerning your particular factual situation and any specific legal questions you may have.
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