we can all agree that Scarlett Johansson and Tom Hiddleston act for a living. Likewise, the artists whose works sell for millions are clearly in the art business. It took a commitment but they’ve transcended the joy of the activity they love to making a living doing it.
But what about the people you’ve never heard of who are engaged in the same activities? They might take classes and get headshots, buy palettes and easels – do all the things they need to do to get a career off the ground. Are they really in the business or are they pursuing a hobby? Sometimes the answer is not clear.
The difference between running a business and engaging in a hobby primarily relates to your intention. Is the person engaged in the activity to make a profit or because they enjoy it and have no real concern about making a profit?
The IRS has provided some guidelines to help make this determination when the lines are blurred. These guidelines don’t necessarily dictate the result but they can help you and the IRS build a case in either direction.
This decision is important. If an activity is a trade or business, the expenses that it generates are deductible as business expenses. Net income derived from such an activity is subject to self-employment tax. If an activity is a hobby, it’s financial aspects are treated differently. Hobby income is reportable as miscellaneous taxable income. It is not subject to self-employment tax since it is not generated by a business activity.
Expenses incurred in pursuing a hobby – (often referred to as “hobby losses” within the tax industry – have not been deductible for most taxpayers since the Tax Cuts and Jobs Act (TCJA) of 2018. Prior to that law, taxpayers could deduct hobby losses as miscellaneous itemized deductions to the extent of their hobby income. Miscellaneous itemized deductions would benefit an individual taxpayer if they itemized deductions and their total miscellaneous itemized deductions exceeded 2% of their adjusted gross income. We’ll have to see whether the miscellaneous itemized deduction will be restored when the TCJA sunsets on December 31, 2025. But, for now, no hobby losses can be deducted by an individual taxpayer.
Note that this rule regarding not-for-profit losses such as hobby losses applies not only to individuals but to partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations. (Some taxpayers create loan-out corporations so the corporation incurs and deducts the expenses related to their activity. This article will not discuss those structures other than to note that the cost of establishing and maintaining them can make their use prohibitive.)
To determine if an activity is a business or a hobby, the first and most clearcut IRS rule is based on the financial results generated by the activity. IRS Publication 535 states, “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.”
For breeding, training, showing, or racing animals, this presumption requires a profit in 2 out of 7 years. If your activity qualifies under this presumption, then you can report it as a business activity and take business deductions and losses in the years in which they are incurred unless other factors to the contrary overcome the presumption.
If your activity does not qualify under this presumption, however, all is not necessarily lost. The IRS has outlined a series of factors that you can consider to determine whether your activity will be treated as an active trade or business or a hobby for tax purposes.
IRS Tax Tip 2023-61, May 3, 2023 continued a series of IRS Tax Tips that list factors to consider in determining whether an activity is a trade or business or a hobby. No one factor is more important than another. This list includes the following questions:
- Is the activity carried out in a businesslike manner and does the taxpayer maintain complete and accurate books and records?
- Does the time and effort the taxpayer puts into the activity show they intend to make it profitable?
- Do they depend on income from the activity for their livelihood?
- Are any losses due to circumstances beyond the taxpayer’s control or are they normal for the startup phase of their type of business?
- Does the activity make a profit in some years and if so, how much profit does it make?
- Do they change methods of operation to improve profitability?
- Do the taxpayer and their advisors have the knowledge needed to carry out the activity as a successful business?
- Can the taxpayer expect to make a future profit from the appreciation of the assets used in the activity?
- Was the taxpayer successful in making a profit in similar activities in the past?
- Does the taxpayer have personal motives for carrying out the activity such as general enjoyment or relaxation?
These questions are not intended to be all-inclusive but represent the types of factors that will determine if your activity is a trade or business or a hobby for tax purposes. Just because you enjoy what you do, that doesn’t mean you’re not doing it to profit. We’ve all heard the saying, “Do what you love and you’ll never work another day in your life.” That’s unless you’re looking at it from a tax point of view!