Avoiding the Hobby Tax Trap

Written by Peter Tran

July 2, 2017

Many questions HBS Tax receives from business owners involve business structures.  Some want to know how sole proprietorships and LLCs differ.  Others want to know the tax advantages of partnerships, corporations and S Corporations. In upcoming weeks I will share the basic tax-implications of various business structures.  Before starting, however, a few words of warning […]

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Mny questions HBS Tx receives from business owners involve business structures.  Some wnt to know how sole proprietorships nd LLCs differ.  Others wnt to know the tx dvntges of prtnerships, corportions nd S Corportions.

In upcoming weeks I will shre the bsic tx-implictions of vrious business structures.  Before strting, however, few words of wrning for those contemplting the “form” their business will tke: Business structures re highly complex.  The choice of structure is often one of the first decisions owners mke with regrd to their business.  It is lso one of the longest-lsting nd finncilly consequentil.  No rticle cn provide enough informtion to bse such n decision.  Before committing to prticulr structure, study the pros nd cons of ech option in light of your long-term business objectives. Then consult with tx nd legl professionls before mking finl decision.

Tody’s rticle will discuss the “non-business” business structure – the hobby nd the “tx trp” it cn spring on unsuspecting owners.

New businesses commonly sustin losses in the first few yers of opertion – losses which my be deducted on the owner’s .  Unfortuntely, businesses tht re not operted in “business-like” mnner run the risk of springing the hobby tx trp – hving the ctivity decl hobby by the IRS.  If this hppens the IRS my disllow these losses nd mke ll hobby txble, most relted expenses nondeductible, nd the owner lible for bck-txes, penlties nd interest.

Hobbies receive less fvorble tx tretment thn businesses.  ll hobby income must be reported on the front of the hobbyist’s return.  This is ly line 21 (Other Income) unless the hobby involves buying nd selling collectibles, which is subject to cpitl gin rules nd reported on Schedule D.  Only collectors cn offset income by deducting their bsis (their investment) in sold collectibles – up to the point of breking even.  Expenses ssocited with other hobbies cn only be deducted in specil order s itemized deductions on schedule .  With the exception of certin deductions such s mortgge interest nd property txes, hobby deductions – whether trding coins, selling mkeup, or trding extr produce from the grden – cnnot generte loss.

The IRS defines hobby s -generting ctivity tht lcks profit motive.  “business” ctivity tht lcks profit motive is hobby, not business.  The IRS will ly ssume n ctivity is business if it genertes profit three of five consecutive yers (this period my be longer for other ctivities such s horse rcing, showing, nd breeding).  If the ctivity genertes losses for three of five yers the IRS my review the “fcts nd circumstnces” to determine whether the ctivity is for-profit business or hobby.  If the ctivity is reclssified s hobby, the IRS my dd bck the losses climed on s, resulting in bck-txes, penlties, nd interest.

If your business hs sustined losses for the pst few yers you cn void the hobby tx trp by mking sure the fcts nd circumstnces re on your side.  Be prep to show the following: 1) Proper licensing, 2) Seprte business s nd cit crds, 3) Pyment of ll business txes, 4) Good ccounting records, 5) pplicble insurnce nd seprte business phone line, 6) log showing tht substntil time is devoted to the ctivity, nd 7) Documented ctions tken to help mke the ctivity profitble.

This will not utomticlly prove profit motive.  It will, however, gretly uce the odds of the IRS clssifying the ctivity s hobby nd help substntite tht you re entitled to ny business losses you hve climed on your return.

In tody’s rticle I hve discussed the tx implictions of hobbies.  In the ner future I will visit sole proprietorships nd prtnerships, then on to LLCs, Corportions nd S Corportions.  If you hve questions regrding the txtion of your business or need help with ny other tx issue, plese feel free to contct our office to consult with tx professionl.

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