When engaging in income-generating activities, understanding how the IRS classifies these activities can significantly impact your tax obligations. The IRS makes a clear distinction between a hobby and a business, and this classification affects the deductions you can claim. In this blog post, we will explore the hobby loss rules, the impact of the Tax Cuts and Jobs Act (TCJA), the nine factors the IRS uses to determine profit motive, and key court cases that provide valuable insights into hobby vs. business classification.
What Are Hobby Loss Rules?
The IRS uses hobby loss rules to distinguish between activities considered hobbies and those classified as businesses. If your activity is classified as a hobby, the income you generate is taxable, but the expenses you incur cannot be deducted for tax purposes from 2018 through 2025. This means that any money spent on the hobby cannot offset your taxable income, making hobby classification less favorable for taxpayers.
Impact of the Tax Cuts and Jobs Act (TCJA) on Hobby Deductions
The TCJA, enacted in 2017, introduced significant changes to the tax code, one of which is the suspension of miscellaneous itemized deductions subject to the 2% of adjusted gross income (AGI) floor for tax years 2018 through 2025. This change means that during these years, hobby-related expenses are non-deductible, while all income from the hobby is fully taxable. Understanding this limitation is crucial for taxpayers who may mistakenly believe they can write off hobby-related costs.
The IRS’s Nine Factors for Determining Profit Motive
To determine whether an activity is carried out with a profit motive (and thus should be classified as a business), the IRS uses nine factors. While no single factor is decisive, they must be considered as a whole:
- Businesslike Manner: Are you running the activity in a professional, businesslike way? This includes maintaining detailed records and books.
- Expertise: Do you have sufficient expertise, or are you consulting with experts to ensure the activity’s success?
- Time and Effort: How much time and effort do you invest in the activity? Significant time invested may indicate a profit-driven venture.
- Expectation of Asset Appreciation: Do you expect the assets used in the activity to increase in value over time?
- Success in Similar Activities: Have you succeeded in similar income-generating activities in the past?
- Income or Loss History: What is the financial track record of the activity? A history of consistent losses may suggest it’s a hobby.
- Amount of Occasional Profits: Are there any profits? If so, how substantial are they?
- Financial Status: Do you have substantial income from other sources? If so, the activity may be more likely classified as a hobby.
- Personal Pleasure: Does the activity provide significant personal pleasure or recreation? High enjoyment may indicate a hobby.
Presumption of Profit Motive
The IRS presumes an activity is engaged in for profit if it generates profits in at least three of the last five years (two of the last seven years for horse breeding, training, or racing). This presumption can be valuable when proving profit motive, but taxpayers need to demonstrate that the activity is profit-driven through detailed records and businesslike operations.
Delaying Determination of Profit Intent
Taxpayers can elect to delay the IRS’s determination of whether an activity is profit-driven by filing Form 5213, which allows postponing this decision until the fourth year of the activity (sixth year for horse-related activities). This option is typically used when under IRS audit for disallowed deductions under hobby loss rules. However, this election should only be made under certain conditions and cannot be applied if the activity has been ongoing for more than five years (seven for horse-related activities).
Deductions for Hobby Income (Before 2018 and After 2025)
For years before 2018 and potentially after 2025 (if TCJA provisions expire), hobby-related deductions are allowed but only up to the amount of income generated by the hobby. These deductions are applied in a specific order:
- Home Mortgage Interest, Taxes, and Casualty Losses: These deductions are allowed first.
- Expenses That Don’t Reduce Asset Basis: Such as advertising, wages, and insurance.
- Expenses That Reduce Asset Basis: Depreciation and amortization fall into this category.
Hobby Income vs. Self-Employment Tax
One key difference between hobby income and business income is the impact on self-employment tax. Hobby income is subject to income tax but not self-employment tax, which can result in lower overall tax liability. Conversely, individuals operating a trade or business must pay self-employment tax, which covers Social Security and Medicare taxes.
Court Cases Involving Profit Motive
Several court cases have examined profit motive, helping clarify how the IRS and courts view certain activities. Below are a few notable cases:
- Groetzinger v. Commissioner (1987): The Supreme Court ruled that a full-time gambler engaged in the business of gambling could claim gambling losses as business expenses, thereby preventing these losses from becoming tax preference items for minimum tax purposes.
- Gajewski v. Commissioner (1983): This case established that a taxpayer who gambled for their own account, without holding themselves out to others as offering goods or services, was not engaged in a trade or business.
- Ditunno v. Commissioner (1983): The court reaffirmed that whether an individual is engaged in a trade or business must be determined by looking at all the facts and circumstances involved.
Examples of Hobby vs. Business
To further clarify the distinction between a hobby and a business, consider these examples:
- Example 1: The Amateur Photographer – Jane enjoys photography and occasionally sells her photos online. However, she doesn’t maintain records or spend significant time on her activity. It’s likely Jane’s photography will be classified as a hobby, and her expenses will not be deductible.
- Example 2: The Professional Photographer – John is a professional photographer who keeps detailed records, spends a significant amount of time on his business, and has a history of profits. His photography is more likely to be considered a business, and his expenses will be deductible.
- Example 3: The Horse Breeder – Sarah breeds and trains horses, generating profits in two of the last seven years. With detailed records and a focus on generating profit, Sarah’s horse breeding will likely be classified as a business.
Conclusion
Understanding the difference between hobby and business classification is crucial for anyone engaged in income-generating activities. The IRS uses a range of factors to assess whether an activity is profit-driven, and the rules surrounding deductions have been significantly impacted by the TCJA. By keeping thorough records, operating in a businesslike manner, and understanding the tax implications, taxpayers can navigate the hobby vs. business dilemma more effectively. If you have questions or need assistance with your tax situation, feel free to contact our office for expert guidance.
