Business or hobby?
One of a tax professional’s favorite discussion topics concerns whether a taxpayer’s activity is a business or a hobby. There is no black-and-white line at which an activity is called a business or a hobby. The tax effect of an activity falling on the hobby side of the line versus the business side of the line is tremendous, though. Let’s look at the tax effect first and then discuss the reasons or factors that come into play in deciding whether the activity is a business or a hobby.
Hobby income, minus the cost of goods sold, is taxable as ordinary income on line 21 of the Form 1040. The remaining expenses are deductible on Schedule A in three different categories.
First, those expenses associated with an office in home such as mortgage interest and property taxes are deducted on the normal tax lines on Schedule A. For example, the taxpayer allocates 15% of his home to the hobby. So, 15% of the mortgage interest and property tax are counted as hobby expenses.
Second, expenses such as advertising, office supplies, travel, dues, subscriptions and the business portion of telephone usage are deductible as miscellaneous itemized deductions subject to the 2% adjusted gross income reduction. These expenses are deductible only to the extent that line 21 income exceeds the 15% of mortgage interest and property tax.
The third category of expense that may be allowed is depreciation. Depreciation is the write-off of the purchase of capital assets, such as computers, scanners and cell phones. This expense is allowed only to the extent that hobby income exceeds both the first and second set of expenses.
There is no mathematical way to claim a loss on a hobby, and the expenses that are deductible can be claimed only on Schedule A. That’s important to note because, in a state like Michigan, itemized deductions are not deductible against Michigan income, so Michigan tax is paid on all of the income.
On the other hand, business income is reported on Schedule C of the Form 1040 with all expenses being deducted directly on the Schedule C against that income. There is no limit to the expenses that can be claimed. Since the net profit or loss is reported on the Schedule C, an additional benefit is gained in that Michigan tax is paid on this net profit or loss figure.
One further tax difference is that self-employment tax at the rate of 13.3% is due on the profit of a business but is not due on a hobby.
What are the factors used to determine if an activity is considered a business or a hobby? A favorite tax term is “facts and circumstances.” The facts and circumstances of each activity determine if that activity is a business or a hobby. If a majority of factors indicate a taxpayer has a business, he has a business. If a majority of the factors indicate the activity is a hobby, the taxpayer has a hobby.
The factors are listed in Regulation section 1.183-2(b). The list is long and one factor is not necessarily more important than another factor. Let’s go over several of the factors.
1. The time and effort expended by the taxpayer in carrying on the activity—Does the taxpayer put forth much effort and spend a lot of time on the activity? Is it one hour a month, one hour a week, or one hour a day?
2. The expertise of the taxpayer in this activity—Is the taxpayer an expert in the area or just learning? Perhaps while learning, the activity could be a hobby. When proficient, it could become a business.
3. The manner in which the taxpayer carries on the activity—Does the taxpayer treat the activity like a business with a separate checking account? Does the taxpayer have business cards, advertise, or belong to the Chamber of Commerce or other professional organizations?
4. Does the taxpayer have a history of starting other activities that have been classed as businesses? Has he turned other activities into businesses that were classed as hobbies?
5. Are there significant elements of personal pleasure or recreation involved in the activity? It’s true that many activities start out as hobbies because people enjoy doing the activity. The tricky spot comes when trying to determine where the activity becomes a business.
6. There is a “presumption of profit” factor itemized in the regulations that can trump all of the previous factors. If the activity is profitable after all expenses are deducted in three out of the last five years, the activity has a presumption of profit. As such, it will be treated as a business and not a hobby.
Whether an activity is a business or a hobby is a conversation that should take place when a taxpayer is starting an activity. It is always an interesting conversation. This is Jerry Coon signing off.
Jerry Coon is an Enrolled Agent. He owns Action Tax Service on Northland Drive in Rockford. Contact Jerry at www.actiontaxservice.com.