Jennifer is a great photographer. She started a small business three years ago to make some extra money with her photography skills during her spare time. She loves what she does, but hasn’t shown a profit in the three years since she started her business. Jennifer has questions as to whether she is really operating a business or just capitalizing on a favorite hobby.
Michael is a skilled handyman. He runs a full-time business performing home repairs and remodeling. He has been in this profession for more than 15 years. For the past two years, Michael’s expenses have exceeded his income, and he is concerned about an Internal Revenue Service (IRS) audit.
Does one of these scenarios seem like a business and the other a hobby? What would the IRS say about Jennifer and Michael’s entrepreneurial endeavors?
The IRS and the United States Tax Court (Tax Court) use the following nine factors to evaluate whether an activity is a business or a hobby:
- Do you conduct the activity in a businesslike manner and maintain proper books and records?
- Does the time and effort invested in the activity indicate you intend to make it profitable?
- Do you depend on this business for your livelihood?
- Are your losses beyond your control, or are they normal in the startup phase of your business?
- Have you changed your methods of operation in an attempt to increase profits?
- Do you and the people around you have the knowledge and expertise needed to carry out the activities of a successful business?
- What success have you had making a profit in other business activities?
- What is the history of your business’s income and losses? Do you have a profit in some years, and a loss in others?
- Can you expect to make a future profit from the assets used in the activity?
The IRS and Tax Court will not expect all nine factors to be met in every situation, and no one factor carries more weight than the other. Unfortunately, it is not enough to simply want to make a profit in your business; you must also have the ability and skills necessary to make the business successful, and you should have a structured business plan.
If I don’t have a business, can I still deduct my expenses from my hobby?
With the Tax Cuts and Job Act (TCJA) of 2017, hobby expenses are no longer deductible as itemized deductions. Prior to the TCJA, you could deduct hobby expenses equal to the amount of income derived from the hobby. You could not claim expenses in excess of your income. So, it becomes important to distinguish the difference between a for-profit activity (business) and a passive-activity (hobby).
Now back to our two scenarios with Jennifer, our photographer, and Michael, our handyman. Applying the nine IRS factors above, it becomes clear that Jennifer’s activity is a hobby or passive income activity. This is an endeavor, outside her full-time job, that she does for friends and family. She doesn’t depend on it for her livelihood and has no expectation of making a profit. She simply enjoys sharing her photography skills.
Michael, though, devotes himself to his business. He has the skills and expertise you would expect for someone in his profession, and he has made a profit far more often than he has incurred a loss. He expects profits each year and depends on this income to support himself and his family. The losses he incurred in the past two years are easily explainable in his professionally kept books and records. He consults with a professional regularly to help him update his business plan. Michael is certainly in the handyman business.
Anyone contemplating starting a business should consider the nine IRS factors, answering these questions honestly. A business or tax professional can help you interpret the regulations to assist you in determining how the IRS views your entrepreneurial endeavors.
If you have questions about the TCJA and the IRS’s nine factors, or would like assistance with tax planning and strategy, business management, or audit and assurance, contact a PYA executive below at (800) 270-9629.