There are ways in which hobby (or sporadic) income and expenses/deductions are treated differently than those of a business and there are ways in which they are treated the same. It's important to know these differences because the US Internal Revenue Service (IRS) and state revenue agencies do.
First, all income from a hobby (or sporadic activity) or a business is subject to taxation. BUT, as indicated before just how much and how it is taxed will vary between the two tax structures.
Second, all expenses/deductions used in a hobby or business MUST be reasonable and necessary, but how they are treated in the calculation for taxable income -- and even some of the forms used -- is different.
Let’s look at an example:
Ima Writer not only earned money writing a newsletter for her friend's business but she also received a Form 1099-MISC. In a panic, she called her friend because she had never seen one of these forms before and wanted to know what it meant. Also, she hadn't realized that she had made as much money as the document indicated because she really didn’t keep track of the income she received.
Her friend calmed her down and advised her to talk with a tax professional. Ima Writer said that she didn't know how to even begin to choose one of those since her return had always been so easy to do in the past. Her friend gave her the name of her own accountant and advised Ima Writer to contact her.
The accountant explained that a 1099-MISC form was issued for a variety of reasons to include reporting to the IRS money tendered to independent contractors such as herself, and that these documents were required when the total amount of money tendered/received at one time, or over a given tax year, was $600 or more.
Perplexed, Ima Writer queried as to what an independent contractor was and the accountant explained that this is someone who provides a service to someone else or to a business, and who is not an employee of that person or business. (More discussion on the difference between an employee and an independent contractor will be presented in a future Blog.)
It was clear that Ima Writer had much to learn about the impact of receiving money for helping her friend and the resulting effect on her federal and state income tax returns. Even though she felt she had earned very little money over the year, she knew she needed to take this situation very seriously. Armed with the advice of the accountant, Ima Writer set out to have a better understanding of just what she had gotten herself into. So, she accessed the IRS website (www.IRS.gov) and downloaded the following publications, forms and instructions for tax year 2013 per the accountant's advice:
Publication 17 - Your Federal Income Tax
Form 1040 Instructions
Schedule A (Form 1040)
Schedule A Instructions (Form 1040)
Form 1099-MISC Instructions
After reading the materials listed above, it was clear to Ima Writer that she would have to include the amount of income indicated on line 3 of Form 1099-Misc on her federal tax return. For tax year 2012 if Ima Writer were considered a hobbyist and not a business then the income reflected on line 3 of Form 1099-Misc would be included on line 21 of Form 1040 as Other Income. Ima Writer will have to confirm that the 2013 version of Form 1040 has Other Income on line 21 as well since tax forms are subject to change each year based on laws passed by Congress.
It is important to note at this time that due to receiving Form 1099-Misc, Ima Writer must now use the federal Form 1040 and is no longer eligible for Form 1040A or Form 1040EZ as she has been in the past. The good news is that with the tax preparation software today it is fairly easy and straight forward to have the income correctly listed on one’s federal and state income tax returns.
Ima Writer believes that she is indeed a hobbyist because she never intended to make a profit and she is not actively seeking to earn money from her writing endeavors. Her friend came to her and basically asked Ima Writer to help out with her business but insisted on paying her for the work that she provided. In the end, Ima Writer’s friend was so pleased with her work that she asked her to produce not only the newsletter but a few brochures as well. Still, Ima Writer only accepted the work when she had time and didn’t treat it as a business.
Ultimately, Ima Writer earned $750 from her writing which is reflected on line 3 of Form 1099-Misc that her friend’s accountant provided. The $750 is the amount of other income that is then included on line 21 of the federal Form 1040. To appreciate the impact that this amount of money could have on someone’s federal income tax return you need to understand that this amount affects what is known as the Adjusted Gross Income (AGI) of an individual’s federal tax return and the AGI affects thresholds for tax credits, brackets and so much more. Additionally, income received on Form 1099-Misc typically does not have any corresponding withholdings sent to the IRS or state revenue department to offset any income tax owed.
We will continue this discussion next week by looking at Ima Writer’s 2012 tax profile and demonstrate how earning $750 as an independent contract impacts that return. At this time we have to use the 2012 forms and rules because the rules for 2013 have not yet been fully released.
Dear Writer – if you haven’t done so already, you too should download the publications, forms and schedules mentioned above, and keep that calculator handy because we're going to keep looking at the numbers just so you can see where the money flows on Ima Hobbyist's federal tax return. We'll also see just how much of her hobby income is taxed and how it affects the rest of her federal tax return calculations.