Costco Connection - December 2012

small business

A guide for hobby businesses

The business “profit” test

The IRS
wants
you
MEDIA BAKERY

By Mark E. Battersby

THANKS TO TODAY’S tough economy, more and more people are using their hobbies and other enjoyable pursuits to generate badly needed income. Unfortunately, few hobbyists may be aware this income is taxable.

Under federal income tax laws, any income, regardless of the source, is taxable. The money earned from a table built in a garage workshop or a painting produced by a part-time artist, even a cash prize from a dog show, can be considered income by the Internal Revenue Service (IRS) and count when computing one’s annual tax bill.

However, under U.S. tax rules, income from these types of activities can be offset or reduced by related expenses—but only to the extent of the income from that activity. Thus, a plane owner who receives money for giving flight lessons can deduct many of the expenses connected with operating the plane, but only up to the amount of money received for those flight lessons.

If a hobby activity is operated as a business, though, those same tax laws permit even more write-offs and expense deductions to the point where they can be used to offset wages, savings and investment income—and the tax bill on that income. And, fortunately, there is more than one way to qualify and label an activity as a business for tax purposes.

The general rule is that an activity is presumed
not to be just a hobby if profits (more income than
expenses) result in any three of five consecutive tax
years ending with the tax year in question. Without
profitable years, anyone can claim a hobby activity is
a business by demonstrating the intent to show a
profit. For example, an artist or craftsperson might
be working toward realizing profits when he or she
has produced sufficient work for a show or catalog.

Mark E. Battersby covers tax topics for publications in a variety of fields.

IN ORDER FOR a hobby to be treated as a business for income tax purposes, a profit motive must be present and some type of economic activity must be conducted. According to lawmakers, among the factors that would ordinarily be taken into account are:

• The manner in which the activity is conducted

• The expertise of the
taxpayer or his or her advisers

• The amount of time and effort expended by the taxpayer in carrying out the activity

• The expectation that assets used in the activity may appreciate or increase in value

• The success of the taxpayer in carrying out other activities

• The activity’s history of income or losses

• The amount of occasional profits, if any, that are earned

• The financial status of
the taxpayer and whether
losses from a money-losing
activity might substantially
reduce his or her taxable
income from other sources
Remember, however:
When it comes to determin-
ing whether an activity is
engaged in for profit, every-
one, including the IRS, must
consider all of the facts and
circumstances. No one factor,
including the fact that the
hobby or activity may be
enjoyable, can be used in
making this determination.