Legal secretary Fannie Hawkins paid $3,000 to Vantage Press, a vanity publisher, to publish a 56-page volume of her poetry, for which she was to receive $1.98 for each of the first 4,000 copies sold at $4.95 each. When only 400 copies sold, Hawkins wrote off $3,000 in losses against her income. The IRS blue-penciled the write-off, asserting that the activity was all for fun--a hobby--not profit. Acting as her own attorney, the Los Angeles taxpayer took her case to the U.S. Tax Court in 1979, which ruled in favor of the IRS. Citing her failure to offer authoritative literary opinion on the book's merit, or plans for future publications that would indicate her intent to earn a livelihood from a writing career, made it unable to "distinguish Fannie from someone who writes for a hobby and pays to have the book published for reasons of personal satisfaction," rather than profit.
However, another Tax Court decision allowed losses sustained by Gloria Churchman, a painter who operated in the red for 20 straight years. The IRS had disallowed the art losses, claiming that Gloria's lack of a profit motive for her artistic endeavors barred an offset of those losses against her husband's income. But an understanding Tax Court sided with Gloria, as she devoted a substantial part of her time to her art activities and acted in a businesslike manner.
In fact, the Internal Revenue Service is showing some mercy toward taxpayers engaged in creative endeavors for profit. It is allowing write-offs to ease the pain of financial losses suffered by writers, photographers, artists and other self-employed individuals. But the same allowances do not apply to those whose creative activities qualify as hobbies. Longstanding rules severely limit what they are able to deduct for losses incurred in pursuing "hobbies." So if your client is a corporate lawyer who dreams of becoming the next Scott Turow, the complex hobby statutes may well be relevant.
For openers, taxpayers are required to report hobby income on the Form 1040 line for "other income." And--no surprise--the IRS wants them to specify "hobby" as the source of the income in the box to the left of the amount. While the service does not subject hobby income to self-employment taxes, it imposes several stipulations for hobby expenses. The key, however, is that those kinds of expenses are allowable only up to the amount of the income generated by the hobby. Furthermore, they cannot be deducted by individuals who use the standard deduction. Hobby expenses are allowable only as miscellaneous deductions on the line for "other expenses" found on Schedule A of Form 1040.
Another restriction is that most miscellaneous deductions are allowable only to the extent that they exceed 2 percent of adjusted gross income. So an AGI of, say, $100,000, means there is no deduction for the first $2,000 of miscellaneous deductions. Worse yet, there is no write-off at all for miscellaneous deductions for someone subject to the alternative minimum tax.
Because of these restrictions, the Feds program their computers to bounce returns that show full-time salaries and other sources of income offset by losses from sideline undertakings that turn out to be hobbies. Activities that are likely to draw the attention of the tax collectors include writing--especially travel writing--photography and painting, to cite just a few.
How do IRS examiners determine whether your intention is to turn a business profit from say, your writing or painting-- or just to have fun? The agents take their cues from Internal Revenue Code Section 183, which provides guidelines on how to distinguish between a hobby and a business. To take advantage of Section 183, you have to establish a profit motive.
In its effort to cut down on disputes, the law presumes that you are engaging in a business-- with the IRS as a partner entitled to a portion of your profits--rather than a hobby as long as you have a net profit in any three out of the last five consecutive years. Net profit is IRS-speak for an excess of receipts over expenses. (By the way, Congress decided that writers and their ilk are not as deserving as individuals involved in the breeding, training, showing or racing of horses. They only have to show net profit in two out of seven years.)
Usually, clients need not worry if they have at least three profitable years during the last four. Satisfy that stipulation, and you are entitled to fully deduct your expenses this year--even if this is a loss year.
But what if you have red ink in more than two out of five years? A much misunderstood point of the regulation is that flunking the three-out-of-five test is not fatal. You still can establish that you conduct a "for-profit" business, provided you pass an IRS "facts and circumstances" test.
These are some of the "circumstances" that the IRS takes into account to determine someone's intention to make a profit:
The way you conduct transactions: Keep accurate and thorough records. Are you really trying to make money as say, a writer or photographer? Usually, someone who submits articles or photos to publications that pay only in copies is a hobbyist.
Do you rely on expert advice? Put another way, do you know what you are doing, or do you hire or consult advisors knowledgeable about your undertaking?
The amount of time and effort you expend in the conduct of your [writing, painting, etc.] career: Here the burden of proof is on you, not the IRS. To back up your deductions in the event of an audit, you should save such records as queries to publishers and programs from conferences. Note, too, that full-time employment in some other field--the case with most freelancers--will not trigger an IRS refusal to classify you as a professional (writer, etc.).
Whether your expectation of profit is based in part on expected appreciation of assets used in your business.
Your success in carrying on other business endeavors.
The history of income or losses from your writing or other undertakings. In particular, is there a string of losses? Be prepared to persuade the Feds that it made sense to endure unbroken financial losses while you were trying to convert the business into a successful operation.
The amount of occasional profits, if any, that are earned.
Your financial status.
The elements of personal pleasure or recreation.
Like so much IRS regulation, however, it's all about interpretation. The United States Court of Appeals for the Sixth Circuit once suggested that the mere fact that a person who writes a single book--in this instance, a lawyer's book about his round-the-world trip--failed to find a publisher for it does not necessarily mean that he was pursuing a hobby rather than engaged in a business venture.
Not so for Maurice Dreicer, another aspiring author, an American living in the Canary Islands on substantial income from a family trust. His desire to become wealthy and famous as a globe-girdling gourmet and "multimedia personality" inspired him to write My 27 Year Search for the Perfect Steak--Still Looking. As Maurice later explained to the Tax Court, he had to "keep his research up to date," a Sisyphean chore that required him to travel to some of the world's best hotels and restaurants in the 60s.
Maurice completed his manuscript, but made only two efforts--both unsuccessful--to publish it. Meanwhile, the big spender's write-offs for 20 years of what he characterized as research totaled$500,000--then quite a substantial sum--mainly to cover travel and food for himself and Brigitte Kimmich, his traveling secretary. His income from writing was south of $16,000. No slouch when it came to gaming the system, Maurice claimed deductions of about $25,000 a year in losses from his sybaritic sorties as an offset to his trust income of roughly $100,000 a year.
Eventually, the IRS got around to denying losses totaling $50,000 for two of those years. The epicure took the dispute to the Tax Court, where he received his just desserts in 1982. The court focused on his lack of expertise and success and his trust income. It ruled that the bon vivant had no realistic possibility of ever earning enough income to offset the large losses from prior years. He enjoyed his life of travel and did not have an honest objective of making a profit. Maurice's case is just one of many in which the IRS persuaded the courts that a string of yearly losses indicates that the enterprise in issue is nothing more than a hobby.
Of course, the outcome for Gloria Churchman, the aspiring artist referred to earlier, was a different story. There, the Tax Court overruled the IRS' determination that she was engaged in a hobby and allowed her 20 years of losses because, among other things, she kept good records of what was sold to whom and continually tried to sell her pictures by exhibiting them and promoting them in other ways, such as writing books that featured her artwork. When sales faltered, Gloria altered her style. Her testimony persuaded the court that she was a dedicated artist who craved recognition and believed she would attain that recognition by deriving a profit from her painting. The court approved the disputed deductions because she showed the required intention to make a profit. Conceivably, the court noted, "she may someday sell enough of her paintings to enable her to recoup the losses which have been sustained in the intervening years."
Writing is also subject to interpretation. Keith Keating, a full-time literature professor, deducted the cost of preparing a taped lecture series on Shakespeare for radio broadcasts. The IRS nixed all of it, asserting that Keith lacked a profit motive for preparing the lectures because he had not been paid for them. But the Tax Court held in 1995 that the IRS should limit its application of the profit-motive requirement to sideline businesses and investments that could serve as tax shelters, as in the case of Maurice Dreicer, discussed above. The court found that Keith had taped the lectures for an entirely different reason--namely, to further his main career as a professor. That being so, the law did not require him to establish a profit motive.
Might it ever be possible to write off what you shell out to indulge your spouse's dreams? "Sometimes" was the pro-taxpayer response of the Tax Court in 1992 to David Krebs, an obliging husband who wanted to help his new wife achieve her goal of becoming a rock-and-roll star. The IRS urged the court to deny David's deductions for studio time, back-up musicians and demonstration tapes on the grounds that it would reward someone who was merely indulging his wife's whim with no profit motive in mind. But David, an entertainment business professional, persuaded the court that he had managed his wife's career in a businesslike manner. Moreover, the court was unwilling to "believe that business and pleasure are mutually exclusive."
A frequently cited Tax Court decision in 1972 allowed losses sustained by Thomas Jackson, a sailing enthusiast who let his yacht out for charter. It was unmoved by the puritanical contention of the IRS that the enterprise was actually a hobby, and that the owner enjoyed sailing. Any writer, artist or photographer who faces a similar attack should find reassurance in the court's response: "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."
Julian Block is an attorney based in Larchmont, N.Y. He conducts continuing education courses for financial planners and other professionals. Information about his books is at julianblocktaxexpert.com.