That’s the admonition to those with or considering a sideline activity if you want good tax results -- "Your sideline business better be for profit."
How you choose to spend your time and effort is one thing, but the tax law makes having a profit motive vital these days.
Overview of hobby activity rules
If you’re in business, you report on your tax return your income and losses (expenses in excess of revenue). But if the activity is merely a hobby (i.e., you engage in an activity that doesn’t have a reasonable expectation of making a profit), then there’s a one-way street you have to follow:
- Report all of your income from the activity. There’s no specific threshold amount; all income is reported.
- Deduct none of your expenses. Until now you could have deducted expenses to the extent of your income from the activity as a miscellaneous itemized deduction. But with the suspension of this write-off for 2018 through 2025, you cannot deduct anything, while all of your hobby income is still taxable.
Business versus hobby
It’s not always easy to determine whether an activity is a business or a hobby. The determination is rather subjective. A particular activity may be a business for one person and a hobby for another.
For example, there are more than 2 million Mary Kay sales consultants worldwide, some of whom depend on their earnings for a living. But others may do so as a sideline activity, and not all of these individuals are in it to make a profit. In one recent case, a full-time project manager earning a great salary decided to also become a Mary Kay sales consultant to earn extra money. Under the Mary Kay system, this money was earned by direct sales to consumers and by recruiting other sales consultants into the Mary Kay distribution system. During the three years she did this, she earned a few dollars, but her expenses—advertising, home office, travel, and more—greatly exceeded her revenue. In fact, her travel expenses (which included vacations with her daughter to Europe and Disney World) exceeded by more than 600% the gross receipts she earned from her Mary Kay activity. She had no sales experience and she didn’t keep records or track her profitability. Bottom line: this was a hobby that she used to try to create tax deductible expenses.
IRS regulations have 9 factors used in assessing a profit motive to determine whether an activity is a business or a hobby:
- The manner in which the taxpayer conducts the activity;
- The expertise of the taxpayer or her advisers;
- The time and effort spent by the taxpayer in carrying on the activity;
- The expectation that assets used in the activity may appreciate in value;
- The success of the taxpayer in carrying on other similar or dissimilar activities;
- The taxpayer's history of income or loss with respect to the activity;
- The the amount of occasional profits, if any;
- The financial status of the taxpayer; and
- Elements of personal pleasure or recreation.
No single factor or group of factors is controlling, nor is it necessary that a majority of factors point to one outcome. (There is a presumption of profit motive that you can rely on, but doing so effectively guarantees an IRS audit.) The bottom line is that its up to you to demonstrate your profit motive by marshalling these factors if your business write-offs are called into question.
Implications for gig workers
Those engaged activities within the gig economy may face IRS challenges if their expenses exceed their income. Here are my suggestions for nailing your tax position with respect to gig work:
- Be profitable (make sure your income is greater than your expenses). This will avoid any IRS question about whether the activity is a business or a hobby. What’s more, you may be eligible for the 20% qualified business deduction for the net income from your gig work, which will significantly trim the tax bill on your profits.
- Treat the activity like a business. Okay, you can’t always be profitable (even Fortune 500 companies lose money from time to time), but you can always act like you’re in business. This means having a separate bank account and credit card, maintaining books and records of income and expenses, and developing a business plan on how you expect to make money.
- When you do have losses from an activity, take steps to become profitable. For example, ask professionals for help, change your operations, re-do your pricing.
Painting for me is a hobby, but this activity may be a business for someone else.
Andy Warhol said: “Making money is art and working is art and good business is the best art.”