The demographic reading this blog does the things necessary to retire early. The same demographic believes in a side hustle to retire even earlier or to fill time once work becomes an elective. These facts make hobby rules an important consideration. The tax law has a massive loophole few use.

Accountants in the room will understand what I say next. A client walks in the door and his hobby finally turned a few dollars of revenue. No worries, the client says, I can lose money in my business for three years before I have to shut it down and start over. The client actually thinks there is a rule saying you must make a profit 2 out of every five years. By this yardstick, Tesla, a publically traded company, would have to shut down. (Tesla has a decade of loses as I write this.)

The rule people think applies to small businesses actually is a hobby rule meant to serve the IRS, not you. If the rule wasn’t there, people like me would have a field day. Self-employment tax would be a thing you only read about.

People want to be a business when they lose money and a hobby (if they knew the rules) when they have a profit. Race car drivers want to write-off $48,721 of expenses because they won $2,100 of prize money racing. Sorry, it doesn’t work that way.

But there is a strategy here you can use to seriously reduce your tax burden.

Why You Want to be a Hobby

Hobby can be a four-letter word coming out of your accountant’s mouth. Hobby income is reported on the front page of Form 1040 as Other Income; Line 21 on the 2016 return. Expenses are deductible on Schedule A, subject to 2%. That means for you need to itemize before any hobby expenses actually reduce any of the hobby income. If you don’t have enough to itemize, all the deductions are lost. It also means the first 2% of your AGI doesn’t count either. A lot of stuff gets shoved into the subject to 2% line. Tax preparation fees, safe deposit boxes and work related expenses also go on the same line. All these items added together have to exceed 2% of your adjusted gross income before it counts.

Example:  If you have a $100,000 AGI, the first $2,000 you claim on Schedule A, subject to 2%, will not help you. If you have $2,000 of hobby income and more than $2,000 of hobby expenses, you have a problem. You can only claim hobby expenses up to the amount of hobby income. In this example, hobby income is $2,000 (claimed on Line 21 of Form 1040) and expenses of $2,000 (the maximum you can claim in this example) do you no good unless there are other deductions to claim, subject to 2%, and if you itemize.

But there is one advantage hobbies have over every sole proprietorship: self-employment taxes. Remember when I said clients with losses want to be a business and clients with profits want to be hobbies? Self-employment tax is the reason why. When you have more expenses than revenue you want to deduct everything so you want to be called a business. When you have profits, you want to avoid the dreaded 15.3% self-employment tax. The only way to do that is to be a hobby. Now you know why the IRS has the three out of five year rule for profits. It is not to determine if you can deduct business expenses; it is to determine if you are a business when you claim to be a hobby. Too many years of profits and the IRS can sock you with self-employment taxes.

Now you know the rules. And if you think about it, you also know how to game the system. But first we need to lay out the rules for determining what a business is before we attempt to game said system (and to keep you reading to the end of the post).

Business versus Hobby

There are nine factors in determining if you are a business:

  • The manner in which you carry on the activity.
  • Your expertise or that of your advisors in the activity.
  • Time and effort spent by you in carrying on the activity.
  • Your success or lack thereof in similar or dissimilar activities.
  • Expectations assets will appreciate in value.
  • Your history of income or losses with respect to the activity.
  • Amount of occasional profits, if any.
  • Your financial status.
  • Elements of personal pleasure or recreation.

Certain actions make it clear you are a business. Your actions play a large role in determining if you are a business or engaged in a hobby. There are reasons to want to be a hobby and times when you want to be a business as fast as possible.

Now I will show you how to put $10,000 or so of side hustle money in your pocket and pay $1,500 less in taxes. You will want to scroll back to the bullet points above as we work through a couple ways to game the tax code.

Make It a Hobby

For all our examples we will assume the same parameters. You have $10,000 of side hustle income with few, if any, expenses. You can play with the numbers on your own to include expenses. Remember, hobby expenses are claimed on Schedule A, subject to 2% of AGI and you can only deduct only up to the hobby income level. My examples are simple so we can work through them easily and compare each situation.

We will start with two examples combined: race car drivers and taxpayers in fishing tournaments. If you have one of these on your tax return, don’t call my office. I don’t want to do the return. You have a hobby and you don’t want to hear that from me. The $842 of income does not allow you to call yourself a business and deduct a $62,000 bass boat, trailer and SUV to haul it. If you won every race or every fishing tournament it would not be enough to turn a profit. If it is impossible to turn a profit you are a hobby. The end.

Look at the list above. You might have expertise, but you get a lot of pleasure from the activity. Pleasure is not an overriding factor. I love doing tax work. My tax practice is NOT a hobby. (Not legally, at least. If they let me call it a hobby I would kill’em on taxes.) There are no profits ever! You lose money fishing or racing and always will. Yes, yes. I know. You think you are Rick Clunn or Richard Petty. For everybody else you are a hobby. Suck it up.

Now it gets interesting. What if you are an Uber driver? Interesting, right? Would you buy a $20,000 car just to earn $10,000 on the side? Probably not. The expense is too much compared to the revenue. And many Uber drivers do it for a while very part-time and then quit. You even get a 1099-MISC telling you you have business income. But do you really?

Picking up strangers for chump change for shits and giggles is not conducting yourself in a businesslike manner. Unless you are also a taxi driver it is doubtful you have prior expertise. Sure you know how to drive and have a driver’s license, but you are acting like someone out to make chump change on the side and move on. You already have more than enough money to retire so you are not doing it to feed the wife and kids. I think many Uber drivers overpay their tax as business owners when they are really carrying on a hobby. Then they stop. They don’t carry on the activity for three years and therefore can’t turn a profit three out of five years. (I see some people leaving the room to call their tax professional right now.)

I could go on, but you get the idea.

Two Problems Solved

There are still two problems to deal with: the pesky 1099-MISC telling you and the IRS you have business income subject to self-employment tax and how to figure out if you will actually turn a profit three out of five years. The future is only clear after it happens.

The 1099-MISC is an easy fix. We will use our Uber drivers again. Uber does their patriotic duty by telling you how much income to report to the IRS. They also tell the IRS in case it slips your mind. The IRS expects to see that income on Schedule C where they can tax the daylight out of it. It is best to tell the IRS computer what it wants to hear. Claim the income on Schedule C and under other expenses list the entire revenue as an expense, listing the item as Hobby Income Reported on Form 1040, Line 21. The Schedule C will have zero profit or loss. Then report the entire income on Line 21 on the front for Form 1040. Any expenses can go on Schedule A subject to 2%. The revenue/profits are only subject to income tax since there is no self-employment tax on hobby income.

The last problem to solve requires you to see the future with absolute clarity. I don’t know about you, but I am darn good at predicting the future. My day trading skills (okay, bad example) proves how well I can see future events.

How do you know if you will turn a profit three out of five years? Heck, when you start you don’t even know if you will want to do it for three years, not to mention five. The last thing you want is the IRS giving you a proctology exam over $1,500. It’ll take more than $1,500 before I allow anyone to probe my backside!

The solution is simple, kind of. You can postpone determination of your activity as a business or hobby by filing Form 5213, Election to Postpone Determination as To Whether the Presumption Applies That an Activity is Engaged in for Profit. (Only the government can create a form with a name like that.) The form is simple to fill out and simple means the statuette of limitations is extended for the hobby issue. A lot of tax software does not have Form 5213. Some hide the form on the Elections screen. You can also scan the completed Form 5213 and attach it to the return. When you efile the return, Form 5213 will go along with it.

Filing Form 5213 starts the clock. You can have two years of hobby gains without a problem. If you have three you need to go back and amend the return because you will file as a hobby while time determines if you are a hobby or business.

Nothing says you must continue an activity. After two years it might be in your best interest to do something else. There are plenty of other side hustles out there. There is also no rule that says you can’t start another hobby. Maybe you try Uber for a year or two and then quit for a side gig preparing taxes for a spell. This could go on forever. (Note on the tax preparation thing: Expertise is one of the determining factors in determining if you are a business. Certain professional businesses walk closer to the line when claimed as a hobby. If you do a handful of returns for friends it is probably a hobby; preparing a hundred for the general public might be a hard sell.)

If you discover you enjoy the profitable hobby enough to continue you will have to file as a business and amend prior returns to reflect the hobby income as business income. You will also have to pay the back tax. The IRS will probably assess an interest penalty, but should not assess any other penalties since you filed the required forms.

I dropped a lot on you guys today. You have enough information to make a solid decision in gaming the tax code to your advantage. Those near or in retirement can kick the crap out of Revenue. Be careful. People like to push this too far. Follow the rules and your side hustle can be a lot less taxing without self-employment tax. Cross the line and a friendly IRS auditor might remind you of the rules I informed you of here.

Most of all, have fun. It’s a hobby.