Is Your Business Really a Business, or a Hobby?

This is a guest blog post by Michelle Loretta of SageWeddingPros

Director Paul Devlin recently wrote a blog post for Filmmaker Magazine on Why Filmmaking Cannot Be A Hobby.  He discusses a legal battle between the IRS and documentary filmmaker Lee Storey in which the IRS claims that Storey is not operating her business as a “for-profit” venture but as a hobby.  While Devlin specifically discusses the implications of this case on his field of documentary filmmaking, the issue of “for-profit vs. hobby” is one that has an impact on business-owners in all creative fields.

The rule (Internal Revenue Code Section 183 – Activities Not Engaged in for Profit) was put into place to deter people from taking excessive tax deductions on their stamp-collecting, golf-playing, and book-reading.  As filmmakers, the law ensures that you are operating a serious business and not that you are having fun playing with a camera.  (Can’t we do both?!)

The IRS sees your business as one of 2 things: a business trying to make an earnest profit, or a hobby.  And, the onus is on you to prove beyond a doubt that you are operating as one or the other.  This is just one of many issues that the IRS has been coming down on small business owners and private individuals in recent years.

Now, here’s something that you may find surprising: you can actually deduct expenses on a hobby from your taxable income. This is called the “hobby loss rule”. Any business without the intention to earn a profit is deemed as a “hobby” and can write off expenses against income – only to a limit.  If the expenses are in excess of income (a loss) the hobbyist cannot deduct them against other forms of income (a day job, a spouse’s job, investment income, etc).

Now, the IRS understands that business owners will face losses.  This is the reality of throwing our dice into the game called entrepreneurialism.  What the IRS doesn’t like is when we lose money year after year after year.  This is made worse in the eyes of the IRS when that loss starts to eat at other sources of incomes.  So the problem isn’t necessarily the loss itself.  You can lose all the money you can tolerate as long as the IRS interprets your business activity as a good faith effort at operating for-profit.

Here’s an example of how this works:

You have $25,000 of equipment rental expenses against $15,000 of business income in year 1.  This leaves you with a $10,000 loss.  If your true intention is to operate for a profit, the IRS is OK with you deducting this loss against your spouse’s income.

But… they’ll start to wonder if you do this year after year.  They’ll start to wonder if they see this repeatedly with people in your field.  It’ll be up to you to prove that this is indeed a for-profit business and not a hobby.

And, this is where it gets tricky.  You may legitimately be operating your business as a for-profit venture.  If you have losses in your history, the IRS may start to question your intentions.  Always on the lookout for us, the IRS has provided a few questions that you can ask yourself in determining your hobby vs. for-profit activity:

• 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?

So, what about all that “fun playing with a camera” stuff?  When Devlin was audited last year by the IRS (a nightmare he describes in full detail) he was advised to not express too much enthusiasm over his filmmaking and to emphasize all of the hard work he does.  (“Remember – this is HARD work! Not play!” is what he was advised.)  Being audited is excruciating and if the question of hobby vs. for-profit comes into play you need to do everything in your power to show that you are a serious business owner.  This may include sharing your filmmaking battle scars and not being overly enthusiastic about how much fun you’re having.

The IRS is pretty black and white.  You’re either in business or engaging in a hobby.  They don’t need to know that most of us in creative fields don’t see the world as black and white.  We can have a successful business and have fun doing it.

Michelle Loretta is a consultant for wedding and event professionals and writes daily for the Sage Wedding Pros’ business blog. She’ll be blending her past as an accounting nerd, sales vixen, and stationery entrepreneur at Posh Retreat this November when she presents “Behind the Mystery of Pricing” to women filmmakers.