At my BlogHer session on blogging and tax, I raised the issue of hobby loss rules. This is an incredibly important matter not only for bloggers but others who work in small or home businesses. Just ask Brenda Konchar.
Brenda Konchar, a Mary Kay Cosmetics representative, reported her Mary Kay activity as business income; the IRS disagreed. Konchar took her case to the Tax Court and lost.
So what? What does it mean?
Here’s the scoop. If you earn income in the pursuit of a hobby, you can offset the income with deductions. You cannot claim deductions that exceed your income – there’s no loss for a hobby.
However, if you earn income in the pursuit of a business, you can not only offset the income with deductions, you can carry any losses forward. This can be huge for new businesses.
Brenda Konchar had deductions which exceeded her income and reported net business losses for the years 1996 through 1998. The IRS disallowed the losses, claiming that Konchar’s activities constituted a hobby. As a backup, the IRS claimed that even if she were operating a business, her expenses were not properly business expenses.
The Regs offer a number of factors to consider when determining whether a taxpayer is engaging in a business or a hobby.
The most important test is the profit motive. The IRS considers that you are engaging in a business when it is your intention to make money. You should be able to demonstrate that you have made a profit for at least three of the last five tax years.
Of course, it isn’t a given that all legitimate businesses will make a profit. So the IRS gives you another bite at the apple. They consider a number of factors, including:
1, Whether you run your business as a business. Sounds simple, right? This includes keeping good records and promoting your business.
2, How much time and effort you expend in the activity. It should go without saying that only spending minimal time and effort on your business sends a message that you’re not so serious about it.
3, Your level of expertise. How much do you know about your business?
4, Your track record. What kind of success or failure have you had in other similar endeavors?
5, Your financial picture. A bona fide business is generally something that a taxpayer relies upon to make a living.
6, Whether you continue to change your business practices in order to make money. When things aren’t going so well in business, business owners switch gears. As your financial picture changes, your business practices should, too.
7, The nature of your losses. All start up businesses expect a few bumps at the beginning. However, continuous losses that may be within your control to change would not be acceptable in a bona fide business.
8, Whether you expect the value of your business to grow. This includes accumulating appreciating assets.
9, How much fun you’re having. Oh yeah, the IRS looks at whether you enjoy yourself. There’s nothing wrong with liking what you do – but if you like it to the exclusion of working at it, you’re going to raise some eyebrows.
So where did Brenda Konchar go wrong? She didn’t operate her Mary Kay activities like a business. She didn’t effectively promote the business – she didn’t even have business cards – and most of her customers were family and friends. She mixed her business assets with her personal assets. She lost money year after year and made no substantial steps to make changes. As a result, her business losses were disallowed.
Here’s the lesson to be learned: if you’re going to operate a business, treat it like a business.
But there’s another lesson to be learned, too. Every endeavor doesn’t have to be a business. If you enjoy selling Tupperware or Mary Kay to friends and family, if you like blogging because you just like putting your thoughts “out there”, if you sell an occasional craft item simply because it feels good, keep on doing things the way you’re doing them. While it’s important to treat a real business like a business, you don’t have to ramp up your hobby activities if your heart isn’t in it.
Remember, the tax tail shouldn’t wag the dog. Choose your path and the tax consequences will follow, not the other way around.
For an interesting perspective on the franchise side of Mary Kay Cosmetics, check out Sean’s series.