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, the IRS feels taxpayers should consider the following factors:

Does the time and effort put into the activity indicate an intention to make a profit?

Does the taxpayer depend on income from the activity?

If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?

Has the taxpayer changed methods of operation to improve profitability?

Does the taxpayer or his or her advisors have the knowledge needed to carry on the activity as a successful business?

Has the taxpayer made a profit in similar activities in the past?

Does the activity make a profit in some years?

Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?

 The “presumption test:  The IRS presumes that an activity is carries on for profit if it makes a profit during at least three of the last five tax years, including the current year (at least two of the last seven years for activities that consist primarily of breeding, showing, training, or racing horses).

 Tax results if activity is a hobby:  If an activity is not for profit, losses from that activity may not be used to offset other 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.

 Deductions for hobby activities are claimed as itemized deductions on Schedule A (Form 1040): These hobby loss deductions must be taken in the following order and only to the extent stated in each of three categories:

Deductions that a taxpayer can take for personal as well as business activities, such as home mortgage interest and taxes, can be taken in full.

Deductions that don’t result in an adjustment to basis, such as advertising, insurance premiums, and wages, can be taken next, to the extent gross income for the activity is more than the deductions from the first category.

Business deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.

Example:Michael D. Storer worked full time as a repairmen for General Motors in Miamisburg, Ohio. Starting in 1993, on the advice of his physician to take up a hobby to help him cope with depression, he became interested in photography and photographic restoration.  Being self-taught, he purchased a large amount of equipment and books, which he deducted on a Schedule C.  His wife assisted as his bookkeeper.  The court concluded that Michael didn’t demonstrate that his photographic activity was carried on with an actual and honest objective of making a profit for the following reasons:

Manner in which taxpayer carried on the activity.  Although the Storers kept very extensive and detailed records of their expenses, but not through a separate checking account, the court believed that these records were maintained solely for the purpose of substantiating their considerable losses and not as a means for tracing costs so as to reduce business-related expenses.  The court commented that the extensiveness of the records would have been more meaningful if the records illustrated that the Storers were tracking expenses while, at the same time, making a bona fide effort to grow their photography enterprise.  In addition, no second telephone line existed, and the photography equipment was insured by their homeowner’s policy.

Time and effort expended by the taxpayers.  The court did not believe Michael’s claim that he spent nearly 1,200 hours working in his photography activity in addition to working full time at General Motors.  After examining the daily entries in Michael’s annual time records (which did not even look to the court as if they were prepared contemporaneously), the court pointed out that almost 80% of Michael’s time was spent either reading photography magazines or shopping at retail stores.  For example, in January 2001, he recorded he spent 14 hours reading Shutterbug magazine, 8 hours reading Outdoor photographer magazine, and 8 hours shopping at Circuit City and CompUSA.

History of losses and financial status.  In each year from 1996-2002, Michael’s claimed Schedule C business losses exceeded $13,000, while his gross receipts from that same time never exceeded $1,600 and were of limited scope.  For example, in 2001, Michael made only 14 sales to friends and coworkers at General Motors – not to the general public.

Elements of recreation.  Probably most important was the court’s belief that Michael principally engaged in photography as pleasurable hobby to reduce his stress and anxiety.  The court pointed out that photography is highly subjective, and in great part, the success of a photography business is dependent on both the skill and talent of the photographer and the marketing and reputation cultivated there from.  The court was “perhaps ultimately persuaded by Michael’s decision to forgo any formal training or education in photography in lieu of reading photography and trade magazines, and picture books featuring works by famed landscape photographer Ansel Adams.  “While the court felt it was beyond the courts purview” to comment on Michael’s ability or potential, we think it unlikely, barring an extraordinary talent, to become Ansel Adams through self-study.” (Michael D. & Susan L. Storer v. Comm., TCS 2007-56)

www.westerncpe.com/June2007