Hobby Expenses, Income, and the 3-out-of 5 Year Tax Rule

Ima Writer continues to research the impact of earning money as a writer on her federal tax return.  She searches “Hobby Expenses” at the IRS website (www.irs.gov) and finds the following reference:

“You can generally deduct hobby expenses, but only up to the amount of hobby income. A hobby is not a business because it is not carried on to make a profit. See Not-for-Profit Activities in Chapter 1 of Publication 535.”

Remember to keep in mind that at the writing of this blog we are using the tax laws for tax year 2012 as a reference since the updated publications for 2013 have not generally been released.  Updated publications are released at the end of the tax year and into January of the following year.  Thus, publications for 2013 will start to become available in December 2013 and into January 2014. One of the helpful features of IRS Publications is that they have a section in the beginning of the publication with updates and changes.  Ima Writer will definitely want to review the 2013 version of all publications related to her situation when they are released.

So, for tax year 2012, Publication 535, Business Expenses, there is a section in Chapter 1 on page 5 titled, Not-for-Profit Activities, as indicated in the reference above.  The interesting aspect of claiming writing or any other type of income as a hobby is that the publication basically describes a process where someone like Ima Writer has to prove she is NOT a business.  There are a variety of reasons for this which we will discuss later.

People often confuse the 3-out-of-5 year tax rule for making a profit as a hobby with the business tax rules and it is important for Ima Writer to understand the difference before going any further.  In the Not-for-Profit Activities section of Publication 535, there is a sub-section titled Presumption of profit which contains the discussion of the 3-out-of -5 year tax rule which is directed at Not-for-Profit Activities.  Essentially, the IRS publication states that if as a Not-for-Profit Activity, such as a hobby, anyone who achieves a profit in 3-out-of -5 years will then be considered a business and therefore must pay business related taxes.  The business related taxes include FICA, which is basically comprised of such taxes as Medicare and Social Security.

So, regardless of deciding to become a hobby or a business, the behavior and nature of the income and expenses of her writing activities will actually determine this for Ima Writer.  It is essential for Ima Writer, and all writers, to keep detailed records of their writing activity, income and expenses because there is a minimum of a 3-year window in which the IRS can audit tax returns.  If it is determined that Ima Writer considered her writing a hobby but then the IRS ruled it a business, her tax returns would have to be amended and her income and expenses reflected on the appropriate forms.  Fortunately, or unfortunately, for most writers in the early years, their expenses most often exceed any income, and tax wise this can be an advantage as a business.

Also, Ima Writer needs to keep in mind that the leading tax preparation software programs today are robust enough to help Ima Writer assess her status as hobby or business as she is inputting her data into the program.

Now, back to expenses for a hobby and how they are treated on the federal tax forms, in particular Schedule A (Form 1040).  The total amount of Hobby expenses will be listed on line 23 of Schedule A (Form 1040) and Ima Writer will “write in” Hobby Expenses on the line provided.

But wait – there’s more!

Hobby expenses are limited to the amount earned from the hobby.  So, if Ima Writer’s expenses were $1200 she can only deduct up to the $750 that she actually earned.

But wait – there’s still more!

Expenses must be deducted in a very specific order AND are limited to 2% of Ima Writer’s Adjusted Gross Income or AGI.  So in Ima Writer’s example who earned $35,000 from her day job and $750 from her hobby, her AGI is $35,750 and 2% of this is $715.  So, her actual amount of deduction will be $35.00.  Keep in mind that in this example we’re only taking into account Ima Writer’s day job income, her hobby income and  her hobby expenses.  Furthermore, the section of Schedule A (Form 1040) where hobby expenses are listed includes other  types of expenses such as tax preparation fees and safety deposit box costs and more, and the 2% floor is a collective one for all expenses in this category.

There are many other financial decisions and consequences that can affect Ima Writer’s AGI but we’ve kept the example simple to illustrate how the hobby expense limit and the 2%-of-adjusted-gross-income limit works.  Publication 535 walks through an example of how listing expenses and applying the 2% limit works.

But wait – there’s still more!

Ima Writer does not have enough other deductions that would cause her to use Schedule A (Form 1040) so in reality and in her current situation, she will not be able to truly deduct any of her hobby expenses nor would any legitimate tax professional advise her to do so.  The reason is that her standard deduction allowed by the federal tax laws – and for 2012 that amount is $7,400 (See IRS Publication 501:  Exemptions, Standard Deduction, and Filing Information) is more favorable for her current tax profile.  Thus $7,400 beats the amount that Ima Writer would be able to claim on Schedule A (Form 1040) in her current tax profile scenario but this could change from year to year so her tax situation needs to be evaluated each year.

So, Dear Writer, go to www.irs.gov and review Publication 535 and Schedule A (Form 1040) for a better understanding of hobby expenses because in addition to the IRS being able to rule a not-for-profit activity as a business, the IRS can likewise rule a business as a hobby and in my opinion that would have more negative impact tax wise for any writer.  We will look soon at how Ima Writer transitions from a hobby to a business and what she must do to maintain her business status.