It has long been known that one of the best ways to escape life’s daily stresses is to pick up a hobby. It allows for an individual to retreat into a world where they have total control. Hobbyists belong to several different categories: the fixers, the collectors and the creators. Oftentimes, hobbyists keep their hobbies to themselves, while others choose to share theirs with the world as a form of supplemental income or as a side business. When anyone turns their hobby into a business, things can get tricky come tax time—especially for the creative or artistic individual.
Due to the unconventional nature of the creative hobby business, it is often difficult to determine the best way to account for profits and losses on tax returns. As most creative people know it is not easy to make a living with their art, music or fashion. Many creatives have a nine-to-five job to make ends meet, yet they still want to express their creativity and, if possible, get paid for it. When tax season comes around artists often discover they spent more money on materials and equipment than they made in income, so they show a loss for their creative venture to offset their normal employment income.
The IRS allows only a certain amount of losses before it considers a business a hobby.
What is rarely explained is that the IRS allows only a certain amount of losses before it considers that business a hobby and disallows the hobby loss offset. This only applies to those individuals who file a Schedule C (Form 1040) with their tax returns. This begs the question: At what point does the IRS consider a business a hobby and not allow the losses of that hobby to be deducted on tax returns? To answer this question we must first address the characteristics of your creative endeavor.
- Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from the activity?
- If there are losses, are they due to circumstances beyond your control, or did they occur in the start-up phase of the business?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
If an artist answers “yes” to one or more of these questions then that activity is considered a business by IRS standards. Once an artist’s production can be classified as a business, the artist must now practice caution when deducting the loss on tax returns. As stated by the IRS, “An activity is presumed for-profit if it makes a profit in at least three of the last five tax years, including the current year.” If an artist has been including profit and losses from their artistic activity on a tax return Schedule C for five years, that business must have made a profit in three of those years. The three profitable years do not have to be consecutive, lessening the burden of a loss following a profitable year.
I know what you are thinking. I already deducted the losses against my employment income for the past two years … What am I going to do about this year? The IRS will allow artists/hobbyists to deduct the expenses related to the hobby, but only to the extent of the income earned from that hobby. Basically, one can only deduct expenses against the income of your hobby-business; artists will not be able to report a loss against other, ordinary income. Here is an example:
Jimi has been creating and selling sculptures for four years. In two of those years, he has deducted losses from his tax returns on his 1040 Schedule C. He is also expecting to take a loss this year as well. Because he has already taken the loss deduction for two years within a five-year period, <span data-scayt_word="Jimi" data-scaytid="3">Jimi</span> will only be able to offset his expenses against the extent of his income.
Mathematically speaking, Jimi made $4,000 in sales, but his expenses totaled $5,200, leaving him with a loss of $1,200 ($4,000 –5,200 = – $1,200). He will not be able to deduct the loss of $1,200 from his tax returns. Fortunately for him, he can carry this loss over to next year and deduct it from those taxes, if he makes a profit.
I usually instruct people to incorporate to avoid these types of limitations. Artists are not too small to incorporate.
Having a hobby and conducting it as a business can be very beneficial. It allows you to do what you love and make money at the same time. Learning how to deal with the tax implications can be a little intimidating and unnerving, but with the right guidance you should not have a problem come the end of the year at tax time. So keep doing what you love: It’s a blessing!
Barry Cooper II is an accountant who has worked with artists and independent business owners for five years in Chicago, Nashville and Los Angeles. He graduated from Robert Morris University with a bachelor’s degree in accounting and is an accomplished musician and producer. His firm, Limelight Accounting, is dedicated to working with artists and creative professionals of all calibers.
Barry Cooper II