Is Your Client’s Activity a Hobby or a Business?

Is Your Client’s Activity a Hobby or a Business?

Pick a Little Talk a Little Pick a Little Talk a Little…

…Cheep cheep cheep talk a lot pick a little more

The importance of communicating with your client in the area of hobby vs. activity engaged in for profit (a.k.a. a business) is always important, but is especially so during the TCJA years. The main reason for the concern involves expenses; while an activity engaged in for profit can produce deductible losses, hobby expenses are limited to hobby income and a reasonably and consistently allocated cost of goods sold. Thanks to TCJA, the rest of the hobby expenses, which prior to 2018 would have been allowed up to the amount of income as miscellaneous itemized deductions, are not allowed during the TCJA years.

With this framework in mind (and using the brilliance of Meredith Wilson’s The Music Man to illustrate the point), let’s imagine a new client walks into your River City office…

You welcome the potential new client, Professor Harold Hill. You will play the part of Marcellus Washburn, a River City Tax Professional.

Marcellus: “Prof. Hill, you mentioned that you are a band leader. We need to determine if your activity is a business or hobby.”

Prof. Hill: “Well, we got trouble, my friend. We got trouble right here in River City. It start with ‘P’ and it rhymes with ‘T’ and it stands for Pool!”

Marcellus: “I’m more concerned that we (you) don’t have trouble right down in DC city with the Feds!!”

Prof. Hill: “Go on my friend and tell me how I can avoid potential malfeasance regarding my business incongruities!” 

Marcellus: “Let’s begin by reviewing the Nine Factors and we’ll do these one at a time:

• Do you carry on the activity in a businesslike manner and maintain complete and accurate books and records. Prof. Hill?  Do you have accurate books and records?
  Prof. Hill: “Well my friend that’s an interesting question which has plagued mankind since the days of Solomon!”   
• Does the time and effort you put into the activity indicate you intend to make it profitable?
  Prof. Hill: “I certainly intend it to be profitable for me!”
• Do you depend on income from the activity for your livelihood? 
  Prof. Hill: “Indubitably!”
• Are your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business)?
  Prof. Hill: “If I lose money, it’s due to the misunderstanding and vagaries of simple people who can’t comprehend the magnitude of my work!”
• Do you change your methods of operation in an attempt to improve profitability?
  Prof. Hill: “Kind sir, I change my method of operation in every town I visit!”
• Do you or your advisors have the knowledge needed to carry on the activity as a successful business?
  Prof. Hill: “Young man, my only advisors are the feeling in my gut and the roar of the crowd!”
• Have you been successful in making a profit in similar activities in the past?
  Prof. Hill: “I will get you my credentials but I left them in my hotel room.”
• Does your activity make a profit in some years and how much profit does it make?
  Prof. Hill: “That depends on the size of the town and the open mindedness of the town folks!”
• So you can expect to make a future profit from the appreciation of the assets used in the activity?
  Prof. Hill: “That depends on how gullible, I mean, reasonable the town’s people are to new ideas!”

Prof. Hill leaves your office after you tell him that you’ll be in touch after he drops off his past records and ‘credentials.’ You find yourself saying “Shipoopi!”

Some commentary about our little “play:”

1. No one factor is supposed to be more important than another, although some IRS auditors have attempted to conclude otherwise and losing in Appeals.
2. A client does not have to meet all nine factors in order to reach a conclusion that the activity is engaged in for profit. But the more positive answers you have, the better.
3. This discussion is not a “one and done” proposition. Taxpayers change how they conduct themselves. Therefore, running through these factors each year is important.
4. When these types of case are litigated, judges will almost always refer to the nine factors.
5. “Safe Harbor” Provision? I have heard many people in our profession claim that a business cannot show more than three consecutive years of losses or the activity will be considered a hobby. That’s not what the rule states. If an activity generates a profit for at least three out of five years (or at least two out of seven years in activities involving horse racing, breeding or showing), then the activity is PRESUMED to be engaged in for profit. That doesn’t rise to the level of a safe harbor, in my opinion. If there are more years of losses, then facts and circumstances will guide the decision. But it doesn’t preclude our taxpayer from having deductible losses. Facts and circumstances, my friends…facts and circumstances.

Practitioner Planning Tip: Just because the bottom line result is a loss does not mean the activity doesn’t rise to the level of a trade or business. As a starting point to your discussion, look at the outcome BEFORE depreciation, Section 179 and/or Bonus Depreciation. You may find the activity is profitable and these accelerated depreciation alternatives which exist today may just be causing a timing difference. 

I would also add a question asking if the activity is conducted with continuity and regularity.

In addition, I want you to think about this. Could a positive outcome result from determining the activity is, in fact, a hobby? I will say yes, and facts and circumstances could save your client self-employment tax on a profitable activity that doesn’t rise to the level of being engaged in for profit. We’re not just talking about hobby rules with activities losing money. Profitable activities could be hobbies as well. Facts and circumstances, my friends.

If you’re just not sure about your client, you can ask the IRS to delay the three out of five rule by filing Form 5213, Election to Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit, and execute a waiver of the statute of limitation. The election on Form 5213 is filed separately from the individual tax return. I will tell you, I’ve never filed one of these forms and have chosen instead to rely on communication and to document the facts and circumstances of the case.

Additional information:

You may find more information on this topic in section 1.183-2 (b) of the Federal Tax Regulations.

Publication 535, Business Expenses

Publication 17, Your Federal Income Tax for Individuals

Category

Small Business, Self-Employed, Other Business

Sub-Category

Income & Expenses

So what did you conclude about Prof. Hill and his band leader activity? Is he engaged in the activity for profit or is it a hobby?  How about giving us your take on our Facebook page?

Would you change your mind next year if Prof Hill comes in, smitten by the love of Marion the Librarian and has settled down to a quiet life in River City, selling musical instruments from a store front and leading a marching band?

I love musicals…

by Tom O’Saben, EA