Clients often think that because their passion automatically equals a business -- but tax authorities are sticklers for precise terminology.
“Passion,” said Enrolled Agent Laura Strombom of All About Numbers in Stockton Calif., “is not one of the elements of defining a business.”
EA Laurie Ziegler at Sass Accounting in Saukville, Wis., does a lot of returns for shop-at-home businesses such as Mary Kay, Pampered Chef and Tastefully Simple. “One of the key distinctions between a hobby and a legitimate business is the intent to make a profit,” Ziegler said. “If a client says, ‘I’m basically in it to get the merchandise at cost,’ that’s a hobby and there are limitations to what can be deducted. On the other hand, I have clients who work the business and are very successful at it. There is definitely a difference on how those two situations are handled on a return.”
“A lot of taxpayers get involved with business ventures with the allure of doing what they enjoy and making money,” said Patrick O’Hara, an EA in Poughkeepsie, N.Y. “These ventures provide them information about what to write-off and the taxpayer gets upset when they find out these things are not exactly true.”
“Anything [clients] take on with a business purpose in mind feels like a business to them,” said Geni Whitehouse, a CPA and “countess of communication” at Brotemarkle, Davis & Co. in St. Helena, Calif. “We have to help them understand the difference between what makes logical sense and how the IRS views the world. It is not always easy.”
‘No one factor’
In making the distinction between a hobby or business activity, take into account all facts and circumstances with respect to the activity, the IRS says: whether the client carries on the activity “in a businesslike manner, whether the time and effort indicate the client’s intent to make it profitable and whether income from the activity constitutes a client’s livelihood, among other conditions.
“All of the rules and the potential violation of them are more like paint strokes,” said EA Juan Macias, of Fourlane in Austin, Texas. “Once all of the strokes have been identified, you have to step back and look at the painting as a whole. That’s when the IRS will say that is a hobby versus a business. Some of the strokes: Do you have other employment? How much time do you put into the side business? And how dependent are you on this business?
“As long as your intent from the beginning is to run a full-function profitable business, you will have an easier time defending the business,” Macias said.
“As Tax Court cases have shown time and again, anything can be a legitimate business. It all is how you document your operations and show your profit motive,” said California-based EA Crystal Stranger, author of The Small Business Tax Guide.
Business from hobby?
“I actually have had a few clients who took a personal passion and tried to make it a business, and I had to explain that it is not necessarily the amount of money made, but the process that you follow,” said Morris Armstrong, registered investment advisor at Armstrong Financial Strategies, in Danbury, Conn. “After all, even really big businesses lose money year after year and no one would think to call them a hobby.”
The important details, according to Armstrong: a business plan, target audience, professional consultants and good recordkeeping. “Some people think that you must show a profit in two of five years, but that seems to be more an aphorism than reality,” he added.
“Ultimately, many small businesses start out as hobbies,” said John Dundon, an EA at Taxpayer Advocacy Services in Englewood, Colo. “The No. 1 issue is timing the specific date when a hobby becomes a business to take full advantage of the tax advantages. Many taxpayers don’t realize, for example, that startup costs are an amortizable deduction. Still others don’t recognize the steps to go through to officially form a business compliant with the laws of their state.”
“I ask [clients] a series of detailed questions. I explain the ‘acting as a business’ and I talk about what they are going to do in regards to this new endeavor,” said Jeffrey Schneider, an EA in Port St. Lucie, Fla. “I haven’t had a client argue with me when I make a determination that the endeavor is really is a hobby. What I have to make them understand is that the income is reportable, even if it’s not from a business. When I tell them that their expenses can bring their gross income to zero, though they cannot claim a loss, they’re fine with that.”
Along with the brashness and blind optimism that can drive a client to believe that their hobby will someday make millions, they can also often arrive full of mistaken tax notions – often fueled by bad past advice.
“Often they think that they, the hobbyist, are given the same tax treatment [as a business] and when they learn different, they believe that all the tax breaks are for everyone else but them,” said Kerry Freeman, an EA at Freeman Income Tax Service in Anthem, Ariz. “It’s hard to change their mind when they’ve heard bits and pieces for different sources that they believe.”
“The biggest misconception is that they actually have a business,” said Eva Rosenberg, an EA and founder of the TaxMama.com blog. “I have had the hard talk with many clients over the years who have shown thousands of dollars’ worth of losses for several years, telling them that they had to stop. Not only did they have no real expectation of ever showing a profit, they were sinking a substantial portion of badly needed family funds into these enterprises.”
“On the other hand, someone who really loves doing whatever it is and doesn't mind the losses is operating a hobby,” added Rosenberg, whose soon-to-be-released book Deduct Everything will include a chapter on hobbies. “Then I have to explain how we must report the income in full but the deductions must be itemized and will face three limitations (they must raise total itemized deductions above the standard deduction threshold, they cannot deduct more of their expenses than the income from the hobby and even those expenses must be reduced by 2% of their AGI).”
“Clients often listen to third parties who are not tax professionals,” Strombom noted, and “often think that any multi-level-marketing business is a legitimate business. Unfortunately, many of the promoters of these businesses will give examples of things people can write off such as business use of home, cell phone, car purchases, meals and travel. People will spend more in these categories with the misunderstanding that a $100 tax deduction does not equal $100 in taxes saved. They will then often have very little income with thousands of dollars in losses, [not understanding] that selling product or recruiting new members is not automatically a business.”
Among the popular misconceptions of clients:
- They get an automatic three years of losses to claim and do not need to prove the pastime is a business until then.
- An occasional small profit qualifies the activity as a business.
- That income from a hobby is reported on the 1040 and the expenses are deducted on Schedule A – if they do not qualify to itemize, they do not get the deductions.
“The biggest misconception is that because they have a desire to convert their hobby into a real business all the expenses should be able to be written off against income to produce a loss,” said Marilyn Heller Ayers, a CPA in Brick, N.J.
Added O’Hara, “Most are told they can deduct travel expenses and deduct the cost of a car because they put a sign on it.”
“Many folks don’t understand that the biggest difference is the ability to show a loss that offsets other income, as with a legitimate business, or to simply offset the gross income, not offsetting other income by creating a loss by expenses exceeding income,” Debra James, an EA at Genesis Accounting & Management Services, in Lorain, Ohio.
“I usually bring the differences up when a new businessperson says that they heard it’s good to show a loss in the first few years,” James added. “My response is, ‘No, it’s never good to lose money.’ I explain the ways to lay the groundwork for proving profit motive. If they get to year three without profit, I get more serious with the discussion and … ask them to seriously consider what they are doing. After all, who would continue to pursue a losing proposition?”
Stranger advises clients to make or reconstitute a spreadsheet that lists on a daily basis business activities and the time involved. “This also is a great way,” said Stranger, “to determine if that business activity is profitable, or has potential to be, and is therefore worth continuing.”