Profit vs. Pleasure: IRS Rules Strict On Losses

PROFIT VS. PLEASURE: IRS RULES STRICT ON LOSSES

by Julian Block

Those obliging folks at the IRS allow write-offs to ease the pain for losses you suffer in ventures entered into to make “profits.” But long-standing rules disallow deductions for losses incurred in pursuing “hobbies.”

Because of that distinction, 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—writing, photography, and painting, to cite just some of the activities that are likely to draw the attention of the tax collectors.

How do IRS examiners determine whether your intention is to turn a business profit from, say, your writing—or just to have fun? They get 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.

To cut down on disputes, the law presumes that you are engaging in a business rather than a hobby—with the IRS as partner who is entitled to a portion of your profits—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, in its wisdom, decided that writers and the like are not as deserving as individuals involved in the breeding, training, showing, or racing of horses. It conferred an easier standard on the latter: two out of seven years.)

So, usually, not to worry when you 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.

A question of profit

What if you have red ink in more than two out of five years? A much misunderstood point 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 in determining your intention to make a profit:

The way you conduct your writing activities—for instance, membership in NASW and other writers’ organizations.
How much time and effort you expend in the conduct of your writing career.
The burden of proof to establish that is on you, not the IRS. To back up your deductions, in the event of an audit, save such records as queries to publishers and programs from writers’ conferences. Note, too, that employment full time in some other field (as is the case with most freelancers) does not trigger an IRS refusal to classify you as a professional writer.
Your success in carrying on other business endeavors.
The amount of occasional profits, if any, that are earned.
The elements of personal pleasure or recreation.
Your history of income or losses from writing. In particular, is there a string of losses?

Your activity has to be real work; you cannot use a hobby that has no income and lots of expenses to offset other income. If you want to write the Great American Novel and have been at it 30 years, if there is no income, there are no deductions.

Julian Block is a syndicated columnist, attorney, and former IRS investigator. This article is excerpted from his Tax Tips for Freelance Writers, Photographers, and Artists. The publication covers key changes introduced by the 2003 tax act, shows how to save money on taxes—legally—and explains the steps to reduce taxes for this year and gain a head start for future years. The book is available (print or e-mailed version) through the author at julianblock@yahoo.com.