You may love what you do but at some point, you gotta eat.
That’s more or less the word from Internal Revenue Service (IRS) when it comes to being an independent contractor.
When you work for someone else – and you get a form W-2 – reporting your income is easy. You enter the information from the boxes on your form W-2 on your tax return. It’s pretty straightforward and there’s little in the way of elections or choices.
When you work for yourself as an independent contractor, reporting can be more difficult. You may get a form 1099-MISC – but not necessarily. You may get a form 1099-K – but not necessarily. You have to report your income even if you don’t receive a form. You also have to make some important choices.
One of the choices that you have to make is how to classify what it is that you do. Specifically: is what you do a hobby or a business? That’s an important question for tax purposes because the two are treated very differently. They are reported on different spots on your federal income tax return (line 21 for hobby income versus Schedule C for business income). They are treated differently for purposes of self-employment tax (business income is generally subject to self-employment tax while hobby income is generally not). Perhaps most important, if you earn income in the pursuit of a hobby, you can offset the income with deductions but you cannot claim deductions that exceed your income – there’s no loss for a hobby. If, however, you earn income in the pursuit of a business, you can not only offset the income with deductions, you can carry any losses forward. These rules are sometimes referred to as the “hobby loss rules.”
Claiming those losses, as you can imagine, is huge for new businesses. Statistically, not everybody makes money out of the gate – many businesses spend more than they make when they’re just getting started. To the extent that you lose money, as a taxpayer, you want to be able to offset any losses when you make money in the future. That’s where being classified as a business can be an advantage.
You can’t just call yourself a business, however. You have to show that you’re operating as a legitimate business. To do that, for the most part, you occasionally you have to make some money.
Howard Berger found this out the hard way. For years, Berger had reported on the Toronto Maple Leafs as a radio announcer. When he was let go from his position, he decided to continue reporting on the Maple Leafs but as an independent blogger. When he started out, Berger claimed pretty considerable expenses and little in the way of income: the result were significant losses. Those losses were largely attributable to travel expenses for road games: Bereger spent nearly $60,000 on hotel and transportation costs. Add in the costs of building a web site, hosting and the like and his expenses dwarfed his advertising and sponsorship income. His balance sheet was grim and taxing authorities didn’t buy the idea that he was running a bona fide business.
His story isn’t all that novel with one exception: Berger appealed the decision and won in court. Berger had to prove that he was operating a legitimate business, just not at a profit. Since that time, Berger has kept at it, but he’s made some changes to his business model. He doesn’t travel to nearly as many away games now which keeps expenses low. At the same time, page views for his site, Berger Bytes, are up – and so are revenues.
It’s worth noting that Berger is Canadian and this was a Canadian tax matter – not a US tax matter. While the two systems often have considerable differences, this is one area where they are remarkable similar. In fact, the same set of facts would likely also have attracted the attention of the IRS with a similar result (denial of losses).
In the US, the IRS has made it clear that it considers profit motive a primary consideration when determining whether you’re engaged in a hobby or a business. While start up costs can be high – just ask Berger – the IRS expects you to be make some money eventually. As a rule of thumb, you should be able to demonstrate that you have made a profit for at least three of the last five tax years.
Of course, all businesses can falter – especially in the beginning – so the IRS looks at a number of other factors, too. Those, as outlined in the Regs at Section 1.183-2(b), include:
- Your business manner. Do you keep good records? Do you work at promoting your business? A real business runs like a business.
- How much time and effort you spend. 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.
- Your expertise. How much do you know about your business? Trying your hand at something new isn’t a deal breaker but the more experience and education in the business you have, the more likely you are to be successful.
- Your track record. What kind of success or failure have you had in other similar endeavors?
- Your financial picture. Remember, you gotta eat. The IRS expects that you’re going to make money eventually. If you’re not – and you’re relying on other money to pay the bills long term – the IRS may think you’re not very serious about your business.
- 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 (remember, that’s what Berger did). Repeatedly doing the same thing while you’re losing money doesn’t send a signal to the IRS that you’re taking your finances seriously.
- The nature of your losses. All start ups expect a few bumps at the beginning. And sometimes, there’s just bad luck and bad timing (think housing bubble). However, losses that appear to be within your control – and you don’t change – may be suspect.
- Whether you expect the value of your business to grow. In some industries, even when you’re not turning a profit, you have the potential to accumulate appreciating assets (real estate, for example). If you’re losing money and not banking assets, the future of your business won’t look encouraging.
- How much fun you’re having. Yes. The IRS looks at whether you enjoy yourself. There’s nothing wrong with liking what you do – but if you like it so much that it’s not really work – especially if you’re not making money – that’s going to raise some eyebrows.
The Tax Court has consistently upheld these factors. One of the more famous cases on the matter, Konchar v. Commissioner, (opinion downloads as a pdf) though not controlling is worth a read. In Konchar, the Court specifically noted that “[n]o single factor is controlling, and we do not reach our decision by merely counting the factors that support each party’s position.” In fact, the Court stated that the outcome of each case will turn on the “relevant facts and circumstances.”
Even though the Konchar case isn’t supposed to be cited as authority, it, like the Berger matter, offers some universal truths – the most important being: If you’re going to operate a business, treat it like a business.
That said, remember that there’s nothing wrong with simply making money from a hobby. Remember that so long as you make money, the tax consequences are pretty much the same for a business as for a hobby (self-employment income notwithstanding). If you like what you’re doing and it only rises to the level of a hobby and you don’t want to make it a business, then don’t.