For-Profit or For Fun? Don’t Make the IRS Guess with Your Business Expense Deductions
Do you want to be able to deduct business expenses? Take the right steps to ensure your business will not be deemed a hobby by a taxing authority come audit time. Pending further guidance from the IRS, an effect of tax reform was the elimination of the hobby loss expenses deduction.
This means that if you get audited, and a taxing authority determines that what you allege to be a business is instead just a hobby, any expenses associated with income generated by the activity would not be deductible on an individual return. Read on for more on the old, the new, and some cases where a taxpayer was rejected for a business classification.
The Way It Used to Be
Before tax reform, you could often deduct hobby-related expenses. They were:
- Limited to the amount of income from the hobby;
- Treated as miscellaneous itemized deduction items; and
- Written off only for amounts exceeding 2% of adjusted gross income (AGI).
The Way It Is Today
Tax reform wiped out deductions from hobby activities. Starting in 2018:
- No more write-offs for miscellaneous itemized deduction items over 2% of AGI;
- You report all of your hobby revenues as income and pay tax; and
- Side gigs should now be expected to come under more scrutiny from the IRS.
Treasury Reg. 1.183-2(b) lists nine factors which are evaluated to determine whether a business is to be classified as a not-for-profit. The regulations state that no one activity is weighed more heavily than others in evaluating an activity. But, from the owner’s perspective, the most important factor should be the first factor mentioned in the regulations—whether the activity is being conducted in a business-like manner.
Conduct your business like it’s your business—keep comprehensive records and be on the lookout for continual ways to turn a profit.
It is a factor that business owners can control, and it is difficult from an audit perspective to make an audit adjustment if the business is conducted in a “business-like manner.” Here are some tips to put into practice right now to protect your business from being deemed a hobby:
- Open and maintain a separate checking account for the business; do not co-mingle personal finances or the finances of other businesses with the business in question,
- Develop a budget and/or income projections,
- Document steps taken to minimize losses—these could include changes in operating techniques, or maybe changes in product mix,
- Create a business plan, and update the plan contemporaneously (at the same time, as you go along). Incorporate the aforementioned changes into the way that you conduct your operations,
- Develop an exit strategy from the business for the potential timeline in which losses continue to an unsustainable degree,
- Document efforts to increase your personal knowledge of the industry in which your business operates,
- Obtain certifications and/or designations in the industry,
- Develop a recordkeeping/bookkeeping system, and use the records maintained to make decisions concerning the business, and
Contemporaneously document time spent on activities.
Times When the IRS Didn’t Think a Hobby Was a Business
(Some names and identifying details have been changed to protect the privacy of individuals.)
Flavorful Fabrication: An individual baked hundreds of cookies multiple times a year for bake sales, and tried to claim it as a business. However, without an established channel through which to generate revenue, their plan quickly crumbled.
Misstatement from an MD: An OBGYN bass guitarist spent a lot of money on:
- Studio time;
- Traveling to other countries to try to recruit band members; and
- Putting together a tour based on liking someone’s music and hoping that they’d go on tour with him/her.
All that, but without a business model. This individual had four separate bands but never cracked $10,000 in income over $100,000 in losses each year. By the time they were audited, they had lost over $1,000,000 US dollars.
There was no evidence that they had used records to make decisions about the business—a big no-no, and why this doctor was given a bitter pill to swallow.
YouTuber Takes Self-Defeating View: A YouTuber expensed travel to collaborate with other YouTubers. They were:
- Not generating any sort of income;
- Didn’t have any plan in place to monetize; and
- Simply trying to grow their channel without a profit-seeking motive.
They did, however, have a donate button. Based on that, they registered with the state as a not-for-profit entity. In doing this, they handed a flawless victory to the state because any deductibility argument would have to have been contingent upon their operation of a for-profit entity. This online personality’s exemption request was sent down the tubes.
In the above cases, there was not sufficient evidence that the proprietor had done their homework to make a viable go at running a business, whether that be through never demonstrating an earnest intent to become profitable, a lack of documentation, or improper classification from the start.
If you have more questions about what it takes to be classified as a business rather than a hobby or are a small business or an individual with tax compliance and planning needs for you and your entity, contact Gloria McDonnell, Partner and Tax Operations Director today.