Many revenue-generated activities are considered a trade or business but there is some confusion when it comes to hobbies with revenue.
- Being a trade or business allows certain tax deductions to be taken, filing requirements to report income earned and paying taxes. Plus, the Tax Cuts and Job Act (TCJA) allows for a Sec. 199A qualified business deduction.
- The IRS has not defined specifically what constitutes a trade or business and has left it to the court cases to differentiate, such as the case Groetzinger 480 U.S. 23 (1987). This case dealt with the status of a taxpayer’s activity as a trade or business vs a hobby. The Supreme Court concluded “to be engaged in a trade or business, the taxpayer must be involved in the activity on a continuous basis and with regularity where the primary purpose must be for income or for profit”.
- If an activity fails to qualify as a trade or business under Sec. 162(a) because it is not engaged in for profit, it is considered a hobby. Sec 162 (a) provides a deduction for all ordinary and necessary expenses paid or incurred during the taxable year to carry on any trade or business. Sec. 183(d) provides that any activity with greater revenue than deductions in at least 3 (three) out of 5 (five) consecutive years, is engaged for profit.
- The following are nine (9) nonexclusive relevant factors the IRS uses to determine profit motive:
- The way the taxpayer carries on the activity
- The expertise of the taxpayer or their advisers
- The time and effort expended by the taxpayer in carry on the activity
- The expectation that assets used in the activity may appreciate in value
- The success of the taxpayer in carry on other similar or dissimilar activities
- The taxpayer’s history of income or losses with respect to the activity
- The number of occasional profits, if any, that are earned
- The taxpayer’s financial status
- Elements of personal pleasure or recreation
- If no profit motive is deemed present, not only does the activity fail to qualify as a trade or business, but the deductions rules of Sec. 183 apply which limits deductions to gross income from the activity, and the deductions must be included among miscellaneous deductions under Sec 67(b), which the TCJA suspended for tax years 2018 through 2025 and in other years are allowed only to the extent they exceed 2% of adjusted gross income.
In conclusion, failing to qualify as a trade or business can have significant tax and filing ramifications.
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