According to IRS estimates, incorrect deduction of hobby expenses account for a portion of the overstated adjustments, deductions, exemptions and credits that add up to $30 billion per year in unpaid taxes. No doubt California contributes significantly to those billions. Tax help is available, however, to address this tax problem before it becomes a major controversy with the Internal Revenue Service.
The Internal Revenue Service provides guidelines to determine whether an activity is a business or a hobby (which is defined as an activity not engaged in for profit). Those of us living and working in Los Angeles County, Orange County, Santa Barbara County or Ventura County would benefit by reviewing those guidelines before a tax problem arises.
The rules for determining if an activity qualifies as a business and what limitations apply if the activity is not a business are explained by the Internal Revenue Service in Publication 535.
In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business. An ordinary expense is an expense that is common and accepted in the taxpayer’s trade or business. A necessary expense is one that is appropriate for the business. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit.
In order to make this determination, taxpayers should consider the following factors:
Does the activity make a profit in some years?
Does the time and effort put into the activity indicate an intention to make a profit?
Have you made a profit in similar activities in the past?
Can you expect to make a profit in the future from the appreciation of assets used in the activity?
If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
Has the taxpayer changed methods of operation to improve profitability?
Do you or your advisors have the knowledge needed to carry on the activity as a successful business?
Do you depend on income from the activity?
If an activity is not for profit, losses from that activity may not be used to offset other income. Losses occur when related expenses exceed income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.
An activity is carried on for profit if it makes a profit during at least 3 of the last 5 tax years, including the current year – at least 2 of the last 7 years for activities that consist primarily of breeding, showing, training or racing horses.
Deductions for hobby activities are claimed as itemized deductions on Schedule A on your individual income tax return. These deductions must be taken in the following order and only to the extent stated in each of three categories:
Deductions that you may take for personal as well as business activities, such as home mortgage interest and taxes, may be taken in full.
Deductions that don’t result in an adjustment to basis, such as advertising, insurance premiums and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
If you have questions about this or other tax problems, please call Mitchell A. Port, Esq. at 310.559.5259 to discuss your situation.