One of the “seasoned” CPAs in our office loves to tell the story of the ugly statues. This story is dredged up whenever someone asks her a question about hobby-loss rules.
Here is the short version of the story:
“My boss, a CPA who did not do taxes, came into my office, leaned over my desk and loudly deposited a ceramic figure. Although the figure resembled a confused baby walrus, it turned out to be a representation of a human child who, as my grandmother would say, ‘Only a mother could love.’ He loudly proclaimed that this was his artist-wife’s creation and that she was planning to spend thousands of dollars on the equipment to produce these statues. In exchange for the lovely sample, he demanded I figure out how he could deduct the inevitable losses of this venture.”
Since 1954, the tax has restricted hobby losses. Over the years, the tax law has evolved in a constant effort to objectively separate hobbies from profit-motive businesses.
There are nine objective factors when considering hobby status.
In 1972, Judge Sterrett of the Tax Court wrote, “A business will not be turned into a hobby merely because the owner finds it pleasurable; suffering has never been made a prerequisite to deductibility.”
Before the most recent tax overhaul, hobby revenue could be offset by hobby expenses. In other words, a hobby that lost money wouldn’t decrease your taxes, but it couldn’t increase your taxes, either. The 2018 change in the rules for itemizing deductions has closed off that option. Now, hobby revenue is taxable, but most hobby expenses are nondeductible.
So classification as a hobby is a tax trap. To avoid this trap, follow every step:
• Obtain a reasonable level of expertise in the field or regularly consult experts.
• Prepare a detailed written business plan, including the project goals, startup costs, projected results and exit plan for an unsuccessful venture.
• Maintain a separate bank account and books and records. Obtain a business license and file required tax returns.
• Document your time and tasks. Your activity should be significant, both in terms of time and importance to the activity.
• If the activity is not successful, make changes.
• Minimize the obviously personal or recreational aspects.
Early in the venture, it may be hard to see future results. In these early stages, one option to consider is treating the initial expenses as startup costs. Startup costs are not deductible immediately but are identified and then deducted over time once the business is up and running.
So what happened with the ugly statues?
“My boss and his wife combined their expertise and adopted a detailed business plan, following all the steps to document their intent. In the first year, not a single statue was sold so there was no revenue. Startup costs were reported on the return without a deduction.
“In year two, a few statues were sold and they began to deduct the startup costs but still reported a loss. Sales took off during year three and the artist was approached by a marketer who not only mass produced the statues, but licensed a (much more attractive) version of the walrus-child on note cards. She sold her rights to the marketer and headed back to her studio, proclaiming her business to be ‘over.’ Her paintings were beautiful; I wish I’d worked up the nerve to ask to swap that statue for a painting.” ￼
Rudy Valdivia is a senior accountant with Brown Armstrong Accountancy Corp. He can be reached at 661-324-4971. The views expressed are his own.