Thanks to today’s tough economy, more and more shop owners are seeking additional sources of revenue. Often it’s from hobbies and secondary activities. Not only will our tax laws partially underwrite those activities, but the almost inevitable losses can be as beneficial as extra income.
Although the tax laws consider all amounts earned from activities such as hobbies as income, the IRS allows all income to be offset or reduced using the hobby activity’s expenses — but only to the extent of that hobby income. If the activity is operated as a business, the tax laws permit even more expense deductions to the point where the activity’s losses offset wages, savings and investment income — and the tax bill on that income from other sources.
Hobbies and hobby businesses
The first question is, obviously, how can a woodworking professional avoid the hobby label for a money-losing secondary business activity or for a hobby that it is hoped will eventually generate income? As a general rule, an activity is presumed not to be a hobby if profits (more income than expenses) result in any three of five consecutive tax years ending with the tax year in question.
Fortunately, there is more than one way in which to qualify an activity as a business. Without profitable years, anyone operating any sort of activity can, if asked, prove the intent to show a profit. What’s more, that intent can be demonstrated using guidelines established by the courts that are now accepted by the IRS.
Quite simply, in order to be treated as a business for tax purposes, a profit motive must be present and some type of economic activity must be conducted. According to our lawmakers, among the factors which would ordinarily be taken into account are the following:
• The manner in which the activity is conducted
• The expertise of the taxpayer or his or her advisers
• The time and effort expended by the taxpayer in carrying on the activity
• The expectation that assets used in the activity might appreciate in value
• The success of the taxpayer in carrying on other similar or dissimilar activities
• The taxpayer’s history of income or losses with respect to the activity
• The amount of occasional profits, if any, that are earned
• The financial state of the taxpayer
• Elements of personal pleasure or recreation
It is quite common for many shop owners or self-employed professionals to have multiple business activities. Consider the situation of John Jones, who has been operating a used-car lot as a sole proprietor for the last five years. He recently opened an auto repair shop near his vacation home in the mountains.
According to the U.S. Tax Court, the used car lot is consistently profitable, while the auto repair business hasn’t yet produced a profit. John Jones reports the two operations as one on his tax returns, offsetting the income and losses.
At first glance, this approach might seem an ideal way to circumvent the rules. In this case, however, the IRS viewed the operations as two separate activities and subjected each to the not-for-profit activity (hobby/loss) rules. Whether or not the IRS will challenge similar offset situations will usually depend on the facts and circumstances.
Expenses incurred in expanding an ongoing business are, in general, currently deductible. However, expenses incurred in starting a new business must generally be capitalized and amortized or written off over 15 years. There is, of course, a special exception: the first $5,000 of expenses can be deducted if the total startup expenses don’t exceed $50,000. Obviously, a significant write-off is available if it can be argued that the new operation is really an extension of the original business.
To illustrate, suppose John Doe operates a custom hardware business and online store. The operation is profitable and he decides to build a shop at the same location that specializes in cabinets. John Doe’s startup expenses amount to $70,000 and include the cost of hiring skilled craftsmen and other help, setting up bookkeeping and an operations manual, as well as advertising and promoting the operation. If this were an integrated operation, John Doe could deduct the startup costs immediately. If not, the rules require they be capitalized and amortized.
In the case of the used-car dealer using the losses from an auto repair shop operated near his vacation home, the geographic separation of the two operations might indicate to an IRS examiner that they are two separate activities. Even worse, the fact that the repair shop is operated by a manager, while John oversees only the used-car lot hurts, rather than helps the argument for an integrated operation.
Of course John Jones, if asked, might be able to convince an IRS examiner (or a court) that the two operations are integrated since both activities involve autos and if John managed both businesses, if the books and records are kept using a common system, if the repair shop regularly does significant repairs on automobiles sold by the used car lot. The integration argument would be a lot stronger if it could be shown that savings resulted by using the repair shop in the mountains.
Working from home
Just as a woodworking business owner or manager, the operator of a hobby-related, secondary business, even someone with only the “intent” to show a profit from his or her secondary activities, is entitled to a tax deduction for the expense of maintaining an office, shop or studio at home. Naturally, a deduction for the expenses of using a home for business purposes cannot be claimed unless the expenses are attributable to a portion of the home (or separate structure) used exclusively on a regular basis.
The home workspace is also deductible if used as the principal place of a business. Generally, a specific portion of a home must be used solely for the purpose of carrying on a trade or business in order to satisfy the exclusive use test. This requirement is not met if the portion is used for both business and personal purposes.
A word of warning: the home office deduction cannot exceed the gross income from the activity, reduced by the home expenses that would be deductible in the absence of any business use (mortgage, interest, property taxes, etc.,) and the business expenses not related to the use of the home.
In a surprising number of cases, the IRS has accepted the characterization of two or more undertakings as one activity unless, of course, the characterization is artificial or unreasonable. The odds of running afoul of the hobby/loss rules also remain long. However, there are situations with which every woodworking professional should be concerned. One such situation involves the so-called “material participation” rules.
Our voluminous tax rules limit the deduction for losses from so-called “passive activities.” Generally, losses from passive activities can’t be deducted from non-passive income (for example, wages, interest or dividends).
A passive activity is one that involves the conduct of any trade or business in which the taxpayer does not materially participate. Materially participating can be measured in a number of ways including putting in more than 500 hours each year. Materially participating also occurs when the individual’s participation constitutes substantially all of the participation in the activity.
The IRS can both tax and help underwrite a secondary, part-time, or hobby-related activity. On the one hand, they are eager to tax all of an activity’s income. On the other hand, many of an activity’s expenses can be used to offset “hobby” income. Operate the activity as a “business,” however, and the amount by which the activity’s expenses exceed its income, the “losses,” can be used to offset income from other sources.
This article originally appeared in the January 2013 issue.