In previous posts, SFWA’s own “Tax Czarina” discussed some basic tax issues writers face, bartering, and the 1099 Misc. form. This week’s post focuses on how the IRS differentiates hobbies from businesses.
Q: Is my writing a hobby or a business?
A: There are a number of factors the IRS looks at. The most important factor is whether or not you have a profit motive. You are not in a trade or business unless you intend to make a profit and have some sort of plan for how you’ll accomplish that. Note that this doesn’t mean you must make a profit. Lots of small businesses fail. But the burden of proof here is on the taxpayer. If you’re losing money, the IRS may assert that you’re engaging in a hobby, especially if you only do it part-time or your primary support comes from another source.
So, wow. That sounds subjective, doesn’t it? Why yes, yes it is. It’s a facts and circumstances test and can be highly individual. Or it could depend on how well you argued your case. It’s an area that was litigated heavily until the Safe Harbor rule was created. Under the Safe Harbor rule, the IRS will assume you are in a trade or business if you make a profit in any three of five years. It doesn’t have to be a large profit and it doesn’t have to offset the losses in the other two years. The rule allows a taxpayer to have loss years at the start of a business or to have loss years due to the cyclical nature of a business…like writing, where one year you get a three-book signing advance and then future income is spread thin over several years until you’re earning regular royalties. (May all your books earn royalties for you!)
The Tax Czarina has a few other things she looks at when clients show losses on Schedule C, the most common form for writers and other entrepreneurs who might be struggling with this hobby v. business issue.
- Was there a loss on Schedule C, but there would have been net income if you removed the home office deduction? Point that out. Mortgage interest and real estate taxes are already deductible on Schedule A. Even if you pay rent and don’t itemize, point it out. You would have incurred that expense anyway.
- Was there a loss on Schedule C, but it was caused by depreciation expense? In other words, you had a positive cash flow, but a tax loss due to a non-cash deduction. Point that out. This might happen when you bought something a few years ago and are still depreciating it.
- Was there a loss on Schedule C caused by accelerated depreciation or allowed expensing? In this case, you could have had net income for that year, but you chose to deduct all of your property purchases in the current year because it was allowed. Point that out. Because you’ve expensed the property or chosen accelerated depreciation, you will have fewer deductions in future years.
- Was there a circumstance beyond your control and you did your best to minimize it? What if your publisher went bankrupt just before your book came out? What if your publisher canceled the last few books in a series before they were paid for? What if your publisher delayed publication for its own reasons? Or, heaven help us all, didn’t pay you what you’re owed and your next stop is the Grievances Committee? Point that out. And then show where you tried to contain costs once you were aware of the situation.
- And finally, does your Schedule C show a trend of decreasing losses over several years? You might not have written that break-out bestseller yet, but you’re getting closer year by year and you can show the trend. It’s just taking longer than the five years used for the Safe Harbor test.
All of the above might explain why the taxpayer didn’t make the Safe Harbor test but was still in a trade or business with a profit motive. Below is a list of other factors the IRS considers in making their determination.
- Do you carry on the activity in a business-like manner? Do you have meetings, make business plans, review cost/benefit calculations, make budgets?
- Does the time and effort you put into the activity indicate that you intend it to be profitable? For most writers, this one is a no-brainer. We spend oodles of time and effort on our writing.
- Do you depend on income from this activity for your livelihood? And if not, do you have a plan and intention to rely on such income in the future?
- Are losses due to circumstances beyond your control (see above) or are they normal in the startup phase of your business (see above)?
- Do you change your methods of operation in order to improve profitability? You’ve gone to the same conventions year after year and you’re not seeing any spike in your sales, any growth. Do you try going to new ones and stop going to some of the old ones to seek out new readers to increase your market, for example?
- Do you (or do your advisors) have the knowledge necessary to carry on the activity as a successful business? This one is pretty self-explanatory. Do you know enough about the industry and about writing and readers? And if not, do you have advisors who do, such as editors, publicists, accountants?
- Were you successful at similar activities in the past? Hmmm, this one is not all that common for writers who tend to stick to writing as their activity, but it’s possible.
- Can you expect to make a future profit from the assets used in the activity? For writers, this one is probably a no. But here’s a story to illustrate it. A client of the firm I worked for had a cow farm that had losses for many years. It never made a profit. And he had a full-time job. He just liked breeding cows. So to keep this from being a hobby, I wrote a research memo that showed that if he were to sell that property, the profit from that sale would offset every loss deduction he had taken. He didn’t have to actually sell the property, he just had to be ready to show that a sale would offset those losses.
In conclusion, those are the various things the IRS looks at to determine whether you’re in a business or a hobby. Businesses can deduct their ordinary and necessary expenses, all of them. Hobbies can only deduct expenses to the extent of hobby income and then only on Schedule A, down in the 2% section (not a good place for it to be, if you want to be able to deduct it) The burden of proving you’re entitled to deduct your business expenses is on the taxpayer. You can meet that safe harbor test over and over and sleep easy. But if you can’t meet the safe harbor test, it doesn’t mean you’re not in a trade or business for profit. It just means you have to be ready to lay out your arguments…like a businessperson does.
The Tax Czarina is a licensed CPA with more than 25 years of experience preparing US Federal and state tax returns. After earning a Masters of Accountancy degree, her resume includes working for the now-defunct largest accounting firm in the world, for the world’s largest cement and construction material firm, and for her own one-woman company, which specializes in individual and small business income tax. She is currently the preparer for SFWA’s tax filings. She is not looking to add new clients.