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.

Writing as a Hobby

At the end of Ima Hobbyist’s first year providing freelance writing services for her friend’s business, she receives a Form 1099-Misc in the amount of $750.  As indicated in our last blog this document confused Ima Writer and she called her friend and asked for more information.  Her friend refers her to her own account who tells Ima Writer that as a business owner her friend was obligated to report all money spent for services and expenses related to her business.  Furthermore, because the amount for the year was more than $600 it required the issuance of the Form 1099-Misc.

Per the last blog, Ima Writer went to the IRS website to download and review the pertinent material that her friend’s accountant referenced and concluded that she was indeed earning the money as a hobby and not as a business. Ima Writer has no intention of making a profit and she doesn’t know if she will even continue to pursue writing for anyone else, even a friend, but in the meantime she has to make sure that she properly files her federal and state individual tax returns.

Because the 2013 federal and state tax forms are not yet available, Ima Writer decides to see what impact the $750 she earned would have on her 2012 tax return in an attempt to better understand the tax consequences of earning income as a hobby.

Ima Writer’s 2012 tax return was a 1040EZ and she earned $35,000 from her day job as a copy writer for a local small business.  She loves her job because she loves writing and even though her salary isn’t as large as if she commuted to the city, she enjoys her options to telework and to potentially earn money writing on the side.  She hasn’t made up her mind about the writing-on-the-side thing because what she really wants to do is write fiction.  She has started what she hopes is the Great American Novel (GAN) but right now it’s just a dream.  This recent twist of earning money as a hobby and having to claim it as income has her realizing that she must have a better understanding of the business side of writing before she goes any further.

After poking around on the IRS website, Ima Writer realizes that there are three levels of the Form 1040 for an individual’s federal tax return.  Until now she has enjoyed the fact that her return has been fairly simple to prepare and that she has been able to use the 1040EZ.  She now understands that because of the hobby income she must use Form 1040 which is the more complicated version of the three choices.

Ima Writer transfers her 2012 tax information to the Form 1040 and adds the $750 to line 21 of Form 1040 listed as Other Income.  She sees from the instructions that she will have to indicate that this is hobby income.  She recalculates her tax and realizes that if she had earned this amount of money in 2012 her federal tax liability would have increased by $112.50 due to the fact that her tax rate on this income for 2012 is 15%.  She must also pay whatever her state tax rate is on this income.  If her state tax is 3% then she would owe an additional $22.50 to the state as income tax on the money earned.

At this point, because she has earned the money as a hobby, she is not able to reduce the amount by any expenses that she had.  That would come later on the Form 1040 Schedule A which we will discuss more next time.

I’ve earned money writing - What do I do now?

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

Form 1040 Instructions

Schedule A (Form 1040)

Schedule A Instructions (Form 1040)

Form 1099-MISC

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.

What do you mean that's taxable!

Before we delve into the tax consequences of earning income from your writing as a hobby, let’s first discuss what the IRS (and statutorily backed by Congress) identifies as income.

Per IRS Publication 525, Taxable and Nontaxable Income, income is defined as that which is received, “…in the form of money, property, or services.”  Furthermore that income is generally taxed if it is “constructively” available to the taxpayer whether it is in the taxpayer’s possession or not.  Moreover, this applies to all income received worldwide and not just in the US or its territories.  Additionally, all income is subject to taxation unless specifically excluded by law or IRS ruling as identified in IRS Publication 525.

So, let’s look at some examples of different types of income that you have the potential of receiving as a writer.

In the previous blog one of the scenarios illustrated a situation where Ima Writer helps her dear friend, Ima Small Business Owner, produce her first newsletter.  Her friend doesn’t have much money so she offers Ima Writer some of her product instead.  This is technically considered a bartering transaction and, at a minimum, is subject to income tax.  Ima Writer constructively received product in exchange for a service of producing a newsletter and must include the value of that product on her individual or business tax return.  Her friend must also reflect the transaction on her individual or business tax return and we’ll come back to that in a later blog as we progress in Ima Writer’s journey.

If Ima Writer’s friend had paid her a small amount of money instead, say less than the going rate for a freelancer’s fees to produce a newsletter, then that money would still be considered income but because it was less than the going rate it would tend to classify Ima Writer as a hobbyist because she didn’t intend to make a profit and the low payment supports this – for the most part.  Still, she must pay income taxes on the money received and we’ll discuss this further when we walk through how this shows up on IMA Writer’s federal income tax return as a hobby.

Let’s say that instead of product Ima Writer’s friend offered to advertise her writing services to other businesses via her store and the newsletter.  This is now an exchange of services and again subject to the federal tax rules.  The trick here is figuring out the Fair Market Value (FMV) of the services and how to report the income on a federal tax return.

In another example, Ima Writer decides to send off a manuscript to a publisher and receives an offer of publication and accepts.  She receives an advance and eventually royalties on the publication of her first novel.  This is considered constructive income.  It’s important to note that the term royalty means something different in the IRS code than it does in the publishing business but there is at least one example when these actually mean the same thing in both arenas and that will be discussed in the future.

Stepping away from the world of writing for a moment, and in an attempt to further illustrate the concept of income as something other than actual money, let’s examine a more familiar situation where two people exchange services.  Two parents decide to exchange watching each other’s children while they run errands, go on social outings, attend classes, etc.  You get the idea.  It’s not difficult to figure out what the going rate for a “babysitter” is.  Just look it up on the internet for your area or try to find someone who will provide child care in your home or theirs. While no money actually changes hands this is a bartering transaction and the exchange of services is a taxable transaction.  Whether or not it has an impact on either person’s tax return depends on the rest of their tax and financial profile, which is something a tax professional can determine.

Regardless of how the income is categorized and how it is reflected on Ima Writer’s tax return, Ima Writer needs to keep detailed records on all income and expense transactions.  Yes, you guessed it, we will be covering record keeping in detail throughout this blog.

So, I hope you’re not getting motion sickness on this windy and bending road of the business side of writing.  Hang in there it will make sense eventually and remember that it’s important to consult a tax professional if you have any questions regarding your specific tax situation and how your writing endeavors do or do not have an impact.

Next time we will run some numbers on the impact of hobby income and expenses on Ima Writer’s federal tax return.  In the meantime, here’s a research assignment:

-          Access the IRS website at www.irs.gov

-          Review and/or download IRS Form 1040 Schedule A and the Form 1040 Schedule A instructions

-          Review and/or download IRS Publications 529 and 535

-          Pay particular attention to hobby income and expenses and the 2%-of-adjusted-gross-income limit.

Are YOU Writing as a Hobby or a Business?  

(This was previously posted at my old site. I have updated some of the information.)

The first question anyone who earns money as a non-employee, not just writers, must ask is - what's the difference between being considered a hobby versus a business?  That is indeed what this first blog is about.

But you also might ask - why even bother caring about the difference between the two? Well, the answer to the second question is that the IRS cares about the difference because Congress directed them to care about it.

The fact that you write or that you call yourself a writer (or author) is irrelevant as far as the IRS is concerned. What does matter is whether or not you earn taxable income from your writing or deduct expenses related to your writing from your taxable income. Either of these will impact on how much you do or do not pay towards your federal, state, and sometimes local income tax obligations.

The first place to start to determine if you, Dear Writer, are a hobby or a business is to examine how you are behaving as a writer. Notice the word behavior, a word that implies that you have at least some control over your writing journey, and indeed you do.

So, let's look at how a hobbyist writer behaves.

Scenario 1:

Ima Hobbyist loves to write but isn't interested in making money from her writing. She mostly writes for herself. She has dabbled in writing the Great American Novel (GAN) but that's just a dream right now. Maybe when her kids are grown she'll take it more seriously, but right now it's just for fun.

In this situation, Ima Hobbyist has no tax obligations because she has not received income nor has she deducted any writing expenses on her tax returns from her taxable income.

Scenario 2:

Ima Hobbyist's friends found out that she loves to write and one of those friends has a small business and needs the occasional brochure or newsletter written for her business. Ima Hobbyist agrees to her friend's proposal that she become her scribe. Ima Hobbyist knows that her friend is just breaking even on her business so charges her very little for her services.

In the above situation, Ima Hobbyist is still writing as a hobby because she's not charging the fair market value for her services and only occasionally provides written product for her friend. In the lingo of the tax code, Ima Hobbyist is not demonstrating an intent to make a profit - a critical element of behaving as a business, regardless the trade. However, she now has to claim the income on her tax return. She can also deduct her expenses but only as a hobby which has stricter limitations than a business. (Stay tuned for this discussion in a future Blog.)

Scenario 3:

Ima Hobbyist continues to write for her friend's business but this time she exchanges her writing services for some of her friend's products.

In this situation, Ima Hobbyist is still writing as a hobby but is earning money from bartering and must report the fair market value on her tax return. A future Blog on the different types of income writers can earn, including bartering income is coming.

So, Dear Writer, consider the scenarios above and see if any of them apply to you.

Soon we will discuss how income earned as a hobbyist affects your federal tax return.