It Pays to Have a Hobby

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.



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Keith Schroeder

13 Comments

  1. Marc on April 12, 2017 at 11:05 am

    Doesn’t a sole proprietorship get half the 15% back as a defucyion for the owner(only)? So wouldn’t you save 7.5%?

    • Keith Schroeder on April 12, 2017 at 2:04 pm

      Marc, you get a deduction, not a credit. This is so you get the same deal as other employers who can deduct all their employment expenses. The actual out of pocket is 14.94% (it shows right on Schedule SE) when you run all the numbers. Rather than muddy the water I either say 15.3% or round to 15%.

      • billy on April 13, 2017 at 7:33 am

        Unless your marginal rate is 4.7% (which nobody’s is), that cannot be correct.

        • Keith Schroeder on April 15, 2017 at 9:28 am

          Billy, you might be misunderstanding. We are talking self-employment tax, not income tax. Self-employed persons pay both their own and the employers portion of the FICA tax (Social Security and Medicare). The combined FICA tax is 15.3%; 7.65 for the employer and 7.65% from the employee. Employers get to deduct FICA taxes as a business expense on their portion. Self-employed people get the same deal by deducting half of their 15.3% self-employment tax. Schedule SE says to multiple your profit by 92.5%. Rather than waste a lot of space on each line of the schedule I included the link here for an in-depth review of the SE tax.

          https://www.irs.gov/pub/irs-pdf/f1040sse.pdf

  2. Noah @ Money Metagame on April 12, 2017 at 6:15 pm

    Hey Keith, I have a question about what stops me from starting an initially unprofitable business in order to write off something that may turn out to be a hobby? You outlined the opposite by filling out the 5213 to delay SE taxes on your potential business, but what if I want to write off expenses now for something that might not pan out.

    Rough example, let’s say I want to become a professional obstacle course racer (OCR). The races themselves have some prize money involved, but I don’t expect to win in my first couple years of competing (have to build up strength and stamina). Everyone knows the real money is in sponsorships and coaching, but I have to establish myself as a competent participant before I can expect to get either. Buying the necessary gear to compete, event tickets, and travel are all expenses that I’m incurring now for my professional OCR business that I don’t expect to break even for at least a year or two. Is there anything wrong with deducting those expenses on a Schedule C for the next year or two while I determine if I can “make it” in the business? If by the third year I can’t make it work, then maybe I just stop altogether. I assume I wouldn’t have to go back and refile to remove those deductions?

    Thanks!

    • Keith Schroeder on April 13, 2017 at 9:10 am

      The question really is “Are you conducting the activity as a business?” “Ordinary and necessary” business expenses are deductible. Profitability is not required every year, but a business must have a profit goal or it is a hobby. Look at the nine bullet points in the post. The more of them you pass the more likely you are a business. #9 is the biggest issue for you. That alone will make it look like a hobby you are trying to write off. There is nothing stopping you from approaching advertisers early on. A “real” business would do that. Document everything. The IRS has a bulls-eye on your type of business. BTW, you don’t need to file a Form 5213 since you are claiming as a business from the get-go. My advice, have a business plan. Outline how you can reach profitability and work the plan. Getting advertiser support early on would help tremendously. If you have zero income and large expenses, expect the IRS to audit and demand an explanation. Better to have your business plan in order early. Personally, I wouldn’t prepare the tax return. Not that you don’t qualify as a business, rather, I value my time too much to invite the IRS in to audit me. That alone will consume up to a year of your life and cost several thousand in accounting fees to defend. And I would not handle an IRS audit without professional help. Knowing these facts, you make the call.

      • Noah @ Money Metagame on April 13, 2017 at 2:08 pm

        Thanks for the information, looks like I won’t plan to start conducting this particular hobby as a business for now. Thanks for the tips in the event I do decide to pursue this as a robust business in the future.

  3. Guillaume McDowell on August 21, 2017 at 5:34 am

    After 2 years of driving for Uber as a hobby, could one switch to driving for Lyft, and restart the hobby clock?

    • Keith Schroeder on August 21, 2017 at 7:43 pm

      Unfortunately, no, Guillaume. Lyft and Uber are essentially identical businesses.

  4. Mike on September 6, 2017 at 11:41 am

    Keith,

    Thanks for the great article. Is there any supporting documentation that can be sent with the filing to support the expensing of all income on Schedule C? I write for a website on the side and I don’t expect the income to amount to more than a couple percent of W-2 income. Thanks!

    • Keith Schroeder on September 6, 2017 at 11:44 am

      I don’t understand the question.

  5. Billy on September 25, 2017 at 6:59 pm

    Can you claim something as a hobby if you’ve already been claiming it as a business in previous years? As in, I come to my senses about the reality of my fishing skills.
    Thanks.

    • Keith Schroeder on September 25, 2017 at 7:19 pm

      A business can become a hobby and vice versa, Billy.Fishing might be problematic.

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