by Edmund Brewer, CPA
Do you want to be able to deduct business expenses? Take the right steps to ensure your business will not be deemed a hobby by a taxing authority come audit time. Pending further guidance from the IRS, an effect of tax reform was the elimination of the hobby loss expenses deduction.
This means that if you get audited, and a taxing authority determines that what you allege to be a business is instead just a hobby, any expenses associated with income generated by the activity would not be deductible on an individual return. Read on for more on the old, the new, and some cases where a taxpayer was rejected for a business classification.
Before tax reform, you could often deduct hobby-related expenses. They were:
Tax reform wiped out deductions from hobby activities. Starting in 2018:
Treasury Reg. 1.183-2(b) lists nine factors which are evaluated to determine whether a business is to be classified as a not-for-profit. The regulations state that no one activity is weighed more heavily than others in evaluating an activity. But, from the owner’s perspective, the most important factor should be the first factor mentioned in the regulations—whether the activity is being conducted in a business-like manner.
Conduct your business like it’s your business—keep comprehensive records and be on the lookout for continual ways to turn a profit.
It is a factor that business owners can control, and it is difficult from an audit perspective to make an audit adjustment if the business is conducted in a “business-like manner.” Here are some tips to put into practice right now to protect your business from being deemed a hobby:
(Some names and identifying details have been changed to protect the privacy of individuals.)
Flavorful Fabrication: An individual baked hundreds of cookies multiple times a year for bake sales, and tried to claim it as a business. However, without an established channel through which to generate revenue, their plan quickly crumbled.
Misstatement from an MD: An OBGYN bass guitarist spent a lot of money on:
All that, but without a business model. This individual had four separate bands but never cracked $10,000 in income over $100,000 in losses each year. By the time they were audited, they had lost over $1,000,000 US dollars.
There was no evidence that they had used records to make decisions about the business—a big no-no, and why this doctor was given a bitter pill to swallow.
YouTuber Takes Self-Defeating View: A YouTuber expensed travel to collaborate with other YouTubers. They were:
They did, however, have a donate button. Based on that, they registered with the state as a not-for-profit entity. In doing this, they handed a flawless victory to the state because any deductibility argument would have to have been contingent upon their operation of a for-profit entity. This online personality’s exemption request was sent down the tubes.
In the above cases, there was not sufficient evidence that the proprietor had done their homework to make a viable go at running a business, whether that be through never demonstrating an earnest intent to become profitable, a lack of documentation, or improper classification from the start.
If you have more questions about what it takes to be classified as a business rather than a hobby or are a small business or an individual with tax compliance and planning needs for you and your entity, contact Gloria McDonnell, Partner and Tax Operations Director today.
Gloria McDonnell is the tax operations director and serves on the leadership team at Redpath and Company. She specializes in corporate and individual tax planning and compliance, multi-state taxation, international tax, and tax research. Gloria works with closely-held businesses in a variety of industries, and has provided business tax accounting services since 1989, and has been at Redpath and Company since 1991.More posts by Gloria McDonnell
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