Keep Personal Expenses off Schedule C: A Lesson From a Recent Tax Court Case
Lately, I’ve been teaching freelance writers what they need to do to treat their businesses like businesses to avoid getting caught in the hobby loss rules. If the IRS determines an activity is a hobby, then expenses can only be deducted to the extent of the income generated, while business losses can offset other sources of income.
Here’s a brief summary of the factors in Section 1.183-2(b) of the Federal Tax Regulations that the IRS uses to determine whether an activity is a for-profit business or a hobby:
- Treat it like a business and keep complete and accurate records.
- Demonstrate expertise and consult with other experts.
- Devote time and effort to the activity.
- Invest in assets that you expect to appreciate.
- Demonstrate a prior history of success in other endeavors.
- Have the intention or expectation of making a profit.
- Enjoying the activity is permissible, but it shouldn’t be only reason to do it.
Simple proactive actions such as opening a business bank account, keeping records and taking care of any required local business registrations can go a long way, but, of course, the best defense is to simply make a profit. According to Section 183, making a profit three out of five years demonstrates that the activity is a business, not a hobby. Those in the horse industry get a break and only have to make a profit two out of seven years.
Keeping business and personal expenses separate is also important, as Aaron Keith Nicholson recently found out with the US Tax Court.
Mr. Nicholson was an engineer by occupation, and found his work stressful. To alleviate that stress, he cultivated his talents as a musician. In 2013 and 2014, he worked with a producer and a recording studio to produce two full-length albums.
His tax returns for those two years contained multiple Schedule Cs for various aspects of his music and artistic endeavors. He reported zero receipts, but had total expenses of $48,017 in 2013 and $21,080 in 2014. With no income, it would appear this would be easy picking for the IRS to invoke Section 183 and disallow all of his expenses.
In the words of the judge, Mr. Nicholson “testified that he is most creative and productive as a musician when he is happy, and that he enhanced his artistic creativity and productivity by dining out with his children, engaging in recreational pursuits such as bowling, hiking and camping, and traveling to new destinations.”
However, for reasons not elaborated in the tax court filing, the five IRS lawyers working the case didn’t mention Section 183 at all. Instead, the court closely examined his expenses and found he had extensively commingled personal expenses with his business expenses.
This included taking his children and their significant others on vacations, dining out and buying equipment for skiing, hiking and camping. Mr. Nicholson did concede that “a baby carrier, children’s books, a stud finder and a chainsaw rental likely were not related to his music activities.”
Interestingly enough, the IRS lawyers did not dispute that Mr. Nicholson had a music business, not a music hobby. Perhaps his records (which weren’t stellar) and other factors about his business and his tax returns that were not mentioned were sufficient in convincing the IRS lawyers that this was indeed a business and not a hobby. Maybe the five attorneys involved were a case of “too many cooks spoiling the broth” . . . or maybe he just got lucky.
In the end, the judge disallowed about half of his business expenses as personal, but allowed business deductions of $29,005 for 2013 and $8,889 against his income as an engineer.
Here are the lessons from this case:
Keep personal expenses off Schedule C. This really should be a no-brainer, but I’ve seen my share of what are clearly non-business expenses woven in among the legitimate ones. These need to be reclassified as owner draws, not expenses.
Keep impeccable records. Mr. Nicholson was able to produce enough documentation to justify the expenses allowed by the court, so this probably helped him out.
If you’re not making a profit, it’s probably not wise to pay your kids as independent contractors. The judge disallowed all of those payments, plus expenses for the benefit of himself and other family members, including a trip to Japan to visit his grandson.
Reminding your clients of the hobby loss rules and the importance of following them will help keep them out of trouble with the IRS.