Tax Implications of Hobby Activities
Many taxpayers have hobbies which can generate income. Especially during the pandemic, taxpayers who lost their jobs, or needed additional income started selling handmade items to produce income. But what are the tax implications of hobby activity?
The Internal Revenue Code defines gross income as all income from whatever source derived. Although the Code does provide for certain exclusions from income, there are no exclusions for income derived from hobby activity. Thus, all income derived from the taxpayer’s hobby activity must be reported as income on Schedule 1 of the 1040 and is subject to income tax. However, income from a hobby activity is not subject to self-employment tax.
The expenses incurred in the hobby activity are not deductible. Thus, if the taxpayer knits, spends $100 on yarn to knit a sweater and then sells the sweater for $150, the full $150 of income must be reported as income. Prior to 2018 the hobby activity expenses could have been deducted as a miscellaneous itemized deduction. However, the law was changed effective beginning with the 2018 tax year and the itemized deduction is no longer available.
You may be asking yourself why expenses from a hobby activity are not deductible. After all, it seems unfair to report income without considering the expenses incurred to generate that income. The reason for this is that a hobby is defined as an activity that a taxpayer pursues for personal enjoyment or recreation and not with the intent to make a profit. This differs from a trade or business which is operated with the intention of making a profit. Thus, a trade or business may deduct expenses it incurs to generate income, but expenses incurred from a hobby activity are not deductible.
In addition, to the deductibility of expenses and the taxation of the income, the determination of whether an activity is a trade or business, or a hobby has other tax implications. Some of these implications are whether any loss generated by the activity can be used to offset other income, whether the health insurance deduction for the self-employed can be claimed, whether the income can be used to calculate contributions/deductions to IRAs or other retirement plans, and whether the alternative minimum tax applies. This is not meant to be an exhaustive list.
From the above, we can conclude that determining whether an activity is a trade or business, or a hobby is very important. It is the taxpayer’s burden to prove that the activity is engaged in for profit and is not a hobby. The IRS has nine factors which must be used to make this determination. All factors are equally important, but more weight is given to objective facts than to the taxpayer’s statement of intent. The factors are:
- Whether the activity is carried on in a businesslike manner and complete and accurate books and records maintained.
- Whether the time and effort the taxpayer puts into the activity show an intention to make the activity profitable.
- Whether the taxpayer depends on the income from the activity for his/her livelihood.
- Whether losses are due to circumstances beyond the taxpayer’s control or are normal for the startup phase for the type of activity being carried on.
- Whether the taxpayer changes methods of operation to improve profitability.
- Whether the taxpayer has the knowledge needed to carry out the activity as a successful business.
- Whether the taxpayer was successful in making a profit in similar activities in the past.
- Whether the activity makes a profit in some years and how much profit is made.
- Whether the taxpayer can expect to make profits in the future from appreciation of the assets used in the activity.
We all know that not all start-up businesses make a profit from the outset even though their intention is to do so. For this reason, the IRS does have a safe harbor rule. Under the law, there is a presumption that the business has a profit motive if in 3 of 5 consecutive years the business is profitable. The presumption is tricky to apply as it only applies after the activity has had three profitable years. In addition, even if the business satisfies the presumption, the IRS can still argue that the business is not a for profit activity. The difference is that the IRS has the burden of proving the lack of profit motive. The rules are slightly different for horse breeding, racing and showing. Further discussion of the presumption and available elections, are beyond the scope of this article.
The fact that a business is not profitable in a particular year does not convert the business into a hobby activity so long as, under the above factors, the taxpayer can show that there was a profit-making motive. The reverse is also true. A business that makes a profit in one year can be classified as a hobby activity in subsequent years if a profit-making motive is not found in subsequent years. The key to prevailing on the question of whether activity is a hobby or a business is to fully document the profit motive for the business for all years in which it is operating in light of the factors set out by the IRS.