Hobby or Business?

Dec 14, 2024 | Financial Matters,

By Sue Greenberg, executive director

For tax purposes, activities earning profits in three out of the last five consecutive years are normally presumed to be businesses rather than hobbies. Creatives who meet the requirement can deduct their business expenses when they file their Schedule C Profit or Loss from Business with their federal tax returns. Generally, if your business deductions exceed your income for the tax year, you can claim a loss, up to the amount of your taxable income from other sources.

What happens if you do not meet the three-out-of-five-year test? Will an IRS auditor automatically consider your artistic endeavors a hobby (no deductions allowed) instead of a business? No! That’s assuming you can prove that you’re conducting your creative business with the clear intent of making a profit.

To make a convincing case with the auditor (taxpayers bear the burden of proving profit motive), experts point to the nine factors the IRS considers in distinguishing hobbyists from serious business owners. Here is the IRS’s list of “objective” and non-exclusive factors along with some tips that will not only help you make your case but also allow your creative business grow:

• Whether you carry on your activity in a business-like manner. Maintain complete and accurate records. Keep a separate bank account and credit card for your business. Avoid co-mingling. Business cards, your website, business email address, invoices, budgets, accurate books, insurance, reasonable goals, and membership in professional associations are also construed as business-like behavior. Like a non-arts business, you should periodically review your sales or promotion strategies and make changes needed to improve profitability.

• Whether you (or your advisors) have the knowledge needed to carry on the activity as a successful business. Document your professional training, practices, and accomplishments. Consult with experts, such as lawyers and accountants, when appropriate.

• Whether the time and effort you spend on the activity indicates that you intend to make it profitable. Keep a log or journal to document your working time and attempts to grow the business. If you are devoting more time to your creative work, you can demonstrate your sincerity even if you are not currently a full-time artist. In fact, nothing requires an activity to be the taxpayer’s sole or principal occupation.

• Whether you can expect to make a future profit from the appreciation of the assets used in the activity. Again, documentation is critical. If your sales and selling prices and/or fees have increased, then you can demonstrate a reasonable expectation of future profits.

• Whether the assets used in the activity may appreciate. Unless you own a Stradivari cello or similar asset, this factor does not apply to most creative businesses.

• Whether you have been successful in making a profit in similar activities in the past. Cite teaching, curating, and writing as well as the activities covered above. Start-up losses or losses sustained due to circumstances beyond your control (such as fire, theft, or depressed market conditions) should not indicate that you lack a profit motive.

• Whether the activity is profitable in some years and how much profit it makes. A long history of losses or small profits could hurt your case. Profitable years that appear artificially created could raise a red flag. So could a loss that results in a large tax benefit.

• Whether you depend on income from the activity for your livelihood. An apparent need for the arts-related income will support your case. Conversely, wealth will not necessarily indicate lack of profit motive.

• Whether you derive personal pleasure from the activity or use it for recreational purposes. You are not required to suffer to produce your art, but you should carefully document all deductions, particularly entertainment and travel expenses.

If you’re audited, look at Churchman v. Commissioner [68 TC 696, 1977], a case that established a precedent for acceptance of artists as being in business without making a profit. Despite a history of losses, the artist was allowed to deduct sufficiently documented expenses.

Crile v. Commissioner [T.C. Memo 2014-202, October 2, 2014] was a victory for artists who teach. Susan Crile is a painter and a tenured professor of studio art. She attracted the IRS’s attention because of the large number of deductions she was taking for her art business. Crile has sold hundreds of pieces during the last 40 years and has work in 25 museum collections. But the IRS argued that teaching is her actual profession. The court ruled for Crile, noting that her day job was clearly a supplement to her main vocation of painting, not the other way around. Crile’s detailed recordkeeping, the time she devoted to producing and marketing her work and a clear profit motive helped persuade the court.

This post is designed to provide general information; it should not be utilized as a substitute for legal and/or accounting services. If legal advice or other expert assistance is required, please consult a professional.