The reporting of gross income and expenses from hobbies has always been a challenging area of federal income tax law. Taxpayers carry out these not-for-profit activities for personal pleasure, and sometimes it becomes more than a personal hobby and produces income. This raises the question of how the individual should treat the income and any associated expenses on his or her tax return. The Tax Cuts and Jobs Act (TCJA) of 2017 may have simplified this tax issue for some taxpayers while making it even more challenging for others.
Reporting of the gross income is simple. It’s the gross receipts received by the taxpayer for the service or product provided. Specifically, in the case of selling products, gross income is the gross receipts less the cost of goods sold (at least these costs can be deducted without itemizing).
The reporting of all the other expenses associated with the activity was trickier under tax law prior to the TCJA. It required a taxpayer to classify the activity’s expenses into one of three categories and then deduct them in sequence. More importantly, the expenses were limited to the activity’s gross income for the year, and they could only be deducted as a miscellaneous deduction after applying the 2% of adjusted gross income (AGI) reduction to all such miscellaneous deductions. Since miscellaneous deductions are itemized deductions, a taxpayer could only deduct the activity’s expenses if he or she itemized and had enough 2% miscellaneous deductions to claim. As a result, the activity couldn’t produce a loss. In many cases, it produced income that increased the taxpayer’s AGI, lowered other itemized deductions, and increased his or her tax liability.
If the taxpayer can demonstrate that the activity was motivated by profit, then the gross income and expenses would appear on Schedule C as a business. Better yet, this means itemization isn’t a factor, and the expenses aren’t limited to the activity’s income. Thus, the business could have a loss that could be claimed against the taxpayer’s other income. The numerous court cases addressing this issue have consistently revolved around the “simple” question: Is the activity a hobby (i.e., a not-for-profit activity) or a business?
HOBBY OR BUSINESS?
Section 1.183-2(b) contains a nonexclusive list of relative factors used when the courts are determining whether a taxpayer engaged in an activity for the purposes of profit:
(1) the manner in which the taxpayer carries out the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on similar or dissimilar activities; (6) the history of income or losses with respect to the activity; (7) the amount of occasional profit, if any; (8) the financial status of the taxpayer; and (9) any elements of personal pleasure or recreation.
No single factor—nor a simple numerical majority of factors—is controlling. Thus, a taxpayer must be able to demonstrate a true commitment to making a profit by pursuing the activity. If a taxpayer has a full-time job, it’s a higher hurdle to demonstrate a true commitment to the activity, as many court case decisions have pointed out. Therefore, it’s critical that a taxpayer has adequate documentation supporting his or her position.
IRC §183(d) provides a safe harbor rule for taxpayers to support a claim that an activity is profit motivated. That is, if the activity generates a profit for three out of the last five years, including the most recent tax year, then the activity is presumed for the taxable year to be an activity engaged in for profit— unless the Secretary of the Treasury establishes to the contrary. In the case of an activity that consists in major part of the breeding, training, showing, or racing of horses, the activity must generate a profit in at least two out of the most recent seven years, including the current tax year. Interestingly, there is no guidance on the level of profit needed; it simply states a profit is realized.
The new tax law simultaneously introduces simplification as well as additional taxes for some taxpayers engaged in a hobby that produces income. The simplification is the elimination of the 2% miscellaneous deduction provision, which means the taxpayer doesn’t need to deal with the three categories of not-for-profit activity expenses. It also means that the taxpayer isn’t able to claim any deductions for the activity’s expenses except for cost of goods sold still being deductible. But the taxpayer is still required to claim the income from such activities.
The concern in this area is that taxpayers may take one of two risky paths because of the TCJA. First, they may decide not to report their income from the hobby. Second, they may decide to claim the hobby is really a business without truly meeting that hurdle or failing to maintain adequate documentation to support the business claim. If the IRS challenges the profit motive and a taxpayer fails to substantiate the profit motive, the taxpayer will lose all the deductions. Both of these situations would likely expose the taxpayer to additional taxes and an accuracy reporting penalty. IRC §6662 provides a penalty equal to 20% of an underpayment if that underpayment is due to a “substantial understatement of income tax,” which is defined as an understatement that exceeds the greater of $5,000 or 10% of the tax required to be shown on the return for the taxable year.
The TCJA doesn’t have any tax effect on those taxpayers engaged in a hobby that has income if the taxpayer doesn’t itemize or doesn’t have enough 2% miscellaneous deductions to claim. A possible positive outcome from the TCJA is that a taxpayer may take the not-for-profit activity to the next level and truly make it a business. From a tax perspective, this outcome would allow the taxpayer to generally deduct any expenses associated with the business. Then it becomes critical that the taxpayer can support the treatment of the activity as a business with a profit motive and not simply a hobby. If it qualifies as a business, the taxpayer will need to pay self-employment tax (if not already doing so), whereas self-employment tax isn’t necessary if it’s a hobby.
© 2018 A.P. Curatola