Harsher Treatment for “Hobbies” After Tax Reform
For probably as long as there has been an income tax code, the IRS has had it in for activities that year in year out run financial losses which an individual taxpayer deducts against other sources of taxable income. These losses help shelter legitimate income from taxation. Or put another way, the deduction tax savings essentially amounts to an IRS subsidy of the loss activity.
The IRS calls such an activity a hobby and not a business. But why does the IRS care if an activity is a hobby versus a business?
This is because per historical tax law, a hobby was not allowed to show a loss for tax purposes due to the aforementioned loss of tax revenue by the government. Any income from the hobby activity was (and is) still reportable as taxable income. However, any hobby expenses could only be deducted up to the amount of that income and no more. Further, hobby expenses were only deductible IF you itemized deductions as a miscellaneous itemized deduction. Taxpayers not itemizing got no benefit from the hobby deductions even though paying tax on the hobby income.
That was the situation at least prior to tax reform that occurred during the Trump Administration. The situation now for hobby activities is actually worse. Under post-reform law, while hobby income is still taxable, hobby expenses are not deductible at all, not even as an itemized deduction. As a result, the IRS has more incentive than ever to go after loss producing activities to attempt to reclassify them as a hobby.
This is particularly the case if the activity is one that has elements of personal enjoyment, recreation or reward associated with it. The government simply does not cotton to subsidizing something that in reality you are doing because you like doing it and not because there is a legitimate profit-making motivation.
What constitutes a hobby isn't clearly defined. A legitimate business endeavor for one taxpayer might very well be a hobby for another. Because there is often litigation to resolve disputes about this between the IRS and taxpayers, due the rather subjective nature of what constitutes a hobby, the courts have had to weigh in.
Here are the main factors that the courts have used to determine when something is a hobby or a business:
- The manner in which a taxpayer carries on the activity
- The expertise possessed by the taxpayer or his/her advisors
- The time and effort expended in carrying on the activity
- Any expectations that assets used in the activity may appreciate in value
- Any prior success in carrying on other similar activities
- The history of income or losses with respect to the activity
- The amount of profits, if any, which are earned
- The taxpayer's financial status
- Any elements of personal pleasure or recreation
None of these characteristics are more conclusive than others, and not all necessarily apply to each given situation. Of course, the more if them you have in your favor, the better!
A classic scenario of this might be a successful entrepreneur who makes her living from several different and highly profitable startup companies she founded. Because she grew up on a farm and enjoys being outdoors, she decides to buy land out in the country and start a "farm". She invests in farm equipment, barns, fencing, etc., and heads to the local sale barn, where she buys cattle and begins to build a breeding herd.
Over the years, the herd grows, she buys and sells cattle and maintains the farm, but never does the farm show a profit. Each year, she dutifully reports the farm operations on her tax return, resulting in healthy tax savings on her other income.
This example is ripe for the IRS to challenge. On the one hand, while she does have income from cattle sales, she has no history of profits. She also doesn't depend on the farm for her living, but instead has other sources of reliable income. Plus, she highly enjoys it and considers it a source of stress reduction and pleasure.
On the other hand, having grown up on a farm, she has a great deal of expertise in the field. She works at it regularly and is hands on, being there virtually every weekend and attending the sales regularly. She also has legitimate expectations that in the end, the farm and its assets will appreciate substantially in value, and that the overall endeavor will be profitable.
Who wins here if the IRS challenges? Hard to say for sure, and of course it could end up in court. It will come down to who has the strongest argument in their favor, and often that may come down to how good her records are supporting her side. (Moral of the story, keep really good records, like a legitimate business would do, and build your case now before the IRS shows up).
Finally, making a profit at your activity occasionally certainly helps your case. There is a presumption under the law that if you make a profit in three out of five years, then it's not a hobby (two out of seven if the activity involves the breeding, training, showing or racing of horses). While the IRS can still challenge that presumption, it's an extra hurdle for them, so they often will not.
With millions of Americans starting their own businesses or adding side gigs to make money during the current pandemic, attention to the issues surrounding the hobby loss rules may be more important than ever.
Lane Keeter, CPA is Office Managing Partner of the Heber Springs Office of EGP, PLLC, CPAs & Consultants, and winner of the 2018 The Sun-Times Reader's Choice Award for Best Accountant
