Your Side Gig Could Be Your Main Tax Headache…Thanks to the Hobby Loss Rule
Imagine this. By day, you’re a software engineer. By night? You’re an author on a mission to publish the next great American novel.
You take writing seriously. It’s your side business. But the IRS isn’t so sure…
If they determine your business is really a hobby, it’s now subject to hobby loss rules. These are rules that limit or flat out eliminate your ability to deduct business expenses and the loss generated by your business. Yikes.
First, we’ll break down the hobby loss rule for you step by step. Then, discover 5 tips to protect your business from the rule.
Tax Implications of Hobby vs. Business
For tax purposes, you want to do everything in your power to ensure the IRS treats your side business as a business – not a hobby (we’ll review those 5 tips next). Here are the calculations that prove just how frightening the hobby loss rules can be:
Let’s say our aspiring author earns $1,000 in 2023 for speaking engagements to other authors. But he spends about $10,000 trying to promote his masterpiece and get it picked up by a major publisher. He suffers a net loss of $9,000.
Author as a Business (NOT Subject to Hobby Loss Rules): $9,000 Tax Advantage
If the author is proactive and uses the 5 tips to show the IRS that he is running an actual business, the following happens. He can use the $9,000 net loss to reduce his taxable income by that amount.
Author as a Hobby (Subject to Hobby Loss Rules): $0 Tax Advantage
Hobby loss rules have always been scary, but now they’re downright terrifying in light of the 2018 Tax Cuts and Jobs Act. It has eliminated your ability to take most miscellaneous itemized expenses related to a hobby until the end of 2015.
Prior to 2018, being told your business was subject to hobby loss rules would be cause for major concern. But even a hobbyist could still deduct miscellaneous itemized expenses up to the amount of income generated by the activity.
That would mean the author could have at least deducted $1,000 from his taxes. Not anymore. Now there’s no tax benefit for our struggling author if the IRS views his writing work as a hobby.
One Glimmer of Hope: You Can Still Deduct “COGs” as a Hobbyist
COGs stands for cost of goods sold. Let’s say some of the author’s expenses involved paying a local printer $2,000 to print some of his books. He then sold these books and made a gross profit of $5,000. According to the hobby loss rules, he can deduct the $2,000 he paid the printer as COGs even as a hobbyist. Then, he is only taxed on the net profit of $3,000.
Are You in it to Win It? How the IRS Determines if the Hobby Loss Rules Apply
Many tax advisors and accountants will say you are safe from the hobby loss rule if your business is profitable 2-3 years out of 5. But that’s not enough. If you generate a loss for all 5 years but put some of the tips below into play, you could still prove that you were, in fact, running a legitimate business.
Plus, business profitability is just one of 9 factors the IRS considers when distinguishing hobbies versus businesses.
You don’t need to meet all 9 of their requirements, but it will increase your chances of avoiding that pesky hobby loss rule.
5 Tips to Prove You’re Running a Business
1) Be Businesslike
Do you run your business…like a business? That means keeping track of expenses, meetings, income, and more. You should also have a basic business plan. Here at Robert P Russo CPA, an actor came to us for help when the IRS stated that her acting pursuits weren’t “businesslike” and she was now subject to hobby loss rules.
Her previous accountant had not explained how critical it was to keep records of her activities. So, we spent time gathering receipts to make her case. We used her Outlook calendar full of auditions to create a journal of business activities.
You might also choose a business entity like an LLC to show that you really do mean business.
2) Are the Expenses Incurred Necessary?
The actor had invested in drama classes, promotional headshots, and travel to auditions. These were all tasks that any actor would undertake. This was important in proving that she was taking the business of acting seriously. It wasn’t just “for fun.”
3) Knowledge is Power…
…especially when trying to avoid hobby loss rules. Another client we took on was attempting to make a career as an artist. She had not been profitable for a few years in a row. Yet, each year she sought guidance and knowledge from advisors in an effort to be profitable. One year it was her local S.C.O.R.E office, another time it was a successful artist.
The IRS states that seeking advice isn’t enough, the advisor must “have the knowledge needed to carry on the activity as a successful business.” We showed that she showed her work at many exhibitions, street fairs, etc.
4) Investment in Assets
Another factor the IRS looks at is how you invest money into your business. If you expect that the assets you invest in will appreciate over time, then you might avoid the hobby loss rule. This factor comes into play in the horse racing world, where the IRS tends to view such businesses as hobbies. In one instance, a couple lost over $14.5 million through their Arabian horse breeding business. The IRS first ruled it was a hobby.
The couple fought it in court – and won. No hobby loss rules for them. One factor the court cited was that the bulk of their investments went into breeding horses – in hopes the horses would become profit-generating assets.
5) Time on Your Side
Again, good record-keeping comes into play. The IRS analyzes how much time you devote to your business. If you’re really trying to turn your side business into your main source of income, you’ll naturally spend a lot of time on it. Showing daily timesheets for an entire year can go a long way in avoiding the hobby loss rules.
Like any tax rule, the hobby loss rule is open to interpretation by the IRS. However, there are basic steps you can take to protect your business. That includes reaching out to a reputable CPA for guidance (use these 7 questions to make sure you hire the right CPA). As always, all of us here at Robert P. Russo CPA are here to help.