The US Tax Court issued an opinion that I think should be considered a win for artists and moonlighters everywhere. Crile V. Commissioner, T.C. Memo. 2014-202.
Generally IRC section 183 acts to disallow taxpayers from claiming losses from activities “not engaged in for profit.” It provides a safe-harbor for activities where income exceeds deductions for at least 3 out of every 5 years. This is great for those who can meet that threshhold, but many pursuing creative endeavors or otherwise struggling to start up a business while working full time cannot. There is a special consideration carved out for those who race and breed horses, who only need to be profitable 2 out of 7 years, but that is a small segment of the population. However, if you are a writer who hasn’t gotten that big book deal, or a musician who has yet to crack the charts or develop a live following, this win is for you.
In practice, the safe harbor has meant that your favorite local auditor would simply presume that your artistic endeavor or other side-venture was “not engaged in for profit” (i.e. a hobby) unless you reported taxable income from it 60% of the time. You then would be faced with the relatively daunting task of proving him wrong via the “hobby loss rules.” If and when he ultimately decided to label it a “hobby,” he would dissallow any deductions in excess of the income derived from that activity. Therefore, you couldn’t use losses from your art, music, home brewery, or other pursuit to offset income from other sources, like your day job.
The “hobby loss rules” which are 9 factors that a court will look at to determine whether you engaged in the activity for profit. However, they have often placed a primacy on the number of years of profits and the amount of profits. This month’s decision went through these factors and found that Susan Crile’s art was not a hobby despite reporting taxable losses in 18 out of the last 20 years. That is only 2 profitable years out of 20!
How did she do it? Well, if you wish to take loss deductions from a particular venture or artistic activity, you need to beef up your other hobby loss factors. The take aways are essentially these (arranged according to the hobby loss factors):
Conduct your activities in a businesslike manner: Keep complete and accurate books and records. Adopt new techniques to increase profitability and abandon old ones that kill efficiency.
Seek out advisors: This does not just mean accountants and lawyers (though those help), but also advisors skilled and experienced in the particular field in which you are engaging.
Spend considerable time on the activity, and be able to prove it.
Appreciable value of assets: Consider whether the value of either your product or business equipment will increase. Incorporating this knowledge and your projections into a business plan would help.
Show your success in other fields: This may help suade the auditor or judge that you have the capacity to be successful in this activity too, particularly if they require similar skills.
Make a Profit!: Nothing says “not a hobby” like paying taxes on it. If you recognize income from your activity, the IRS probably will not hassle you too much.
Quantify the big payoff: Even if you have not hit it yet, be able to show that there is great income potential in your work, enough to justify the continued losses. This could mean a major label recording contract or the sale of your app to Google.
Don’t have too much fun: While this may sound like a joke, try and keep a straight face. The elements of personal pleasure you derive from your chosen activity counts against you. Of course, the court has said that “suffering has never been made a prerequisite to deductibility.” Jackson v. Commissioner, 59 TC 312, 317 (1972).
I would typically go into a deeper breakdown of the factors and how you can set yourself up for similar success. However, Tony Nitti wrote a great article for Forbes that I will direct you to for a deeper analysis.
Come back soon.
Thanks for reading,