So, you love your job. But did you know that combining business and pleasure could affect your tax deductions? While there are no laws against enjoying your profession, it is important to distinguish between business and recreation when it comes to your taxes. If your operation runs at a loss and you claim losses on your taxes, it is critical to understand the hobby loss rule and how separating business and pleasure is essential to complying with tax rules.
The hobby loss rule
The hobby loss rule was adopted in 1969 as an attempt to deter farmers from deducting losses from not-for-profit activity. The historical phrase “gentleman farming,” refers to a person utilizing his estate or land for farming pleasure rather than profit.
Essentially, the wealthier landowners would claim agricultural losses on their land to offset their regular income — thus stretching the rules to maximize wealth. Still in effect today, hobby loss rules seek to strictly distinguish between for-profit and not-for-profit activities.
Like farming, wineries are eligible to receive tax deductions in the case of a rough year with heavy losses. While this is particularly beneficial in the case of drought or extreme weather, there are certain rules that limit the extent to which you can use vineyard and winery losses as a tax deduction.
How does the tax deduction work?
Traditional business expenses are generally tax deductible so long as the expenses were a result of trade or business activity — basically expenses relating to the production of income or activities relating to investments. Perhaps most notably, a trade or business loss deduction may be offset against unrelated income, depending on the circumstances.
A “hobby loss” on the other hand, is a non-deductible loss incurred because of doing an activity for pleasure rather than profit. Covered under Internal Revenue Code 183, hobby loss limits the deduction of losses not directly associated with profit. Therefore, an individual, trust or estate may deduct hobby loss expenses only to the extent that the individual has gross income from the activity.
Separating hobby and profit
So how do you decipher between hobby and for-profit activities? Deciding whether someone engages in a for-profit activity depends on whether they have an honest profit goal — which often becomes a test of facts and circumstances. In some cases, the fact that an individual spends personal time cultivating an activity indicates their intent to make a profit. This is especially true when the activity in question lacks substantial personal or recreational aspects. Someone choosing to leave a former occupation to devote more time to another activity may also indicate a profit motive. In addition, profit motive may be presumed if the activity in question was profitable for three of the past five years.
Hobby vs business
If profit intent is ever questioned, the courts will generally put more weight on objective facts rather than the individual’s claims. For this reason, it is important to have your activities clearly separated from the beginning in case the IRS ever questions your motive. The Internal Revenue Code regulations identify nine factors (none of which are individually determinative) to help decipher whether an activity was engaged in for profit:
- The extent to which an individual carries on the activity in a businesslike manner
- An individual’s expertise or reliance on the advice of experts
- The time and effort an individual expends in carrying on the activity
- The expectation that the assets used in the activity may appreciate in value
- An individual’s success in similar activities
- An individual’s history of income or loss from the activity
- The amount of occasional profits, if any
- An individual’s financial status
- The elements of personal pleasure or recreation
Steps to avoid the hobby loss rules
There are a few steps that individuals can take to avoid the hobby loss rules. First, the individual should strive to conduct the activity professionally and in a businesslike manner. You should:
- Document your acquisition of a reasonable level of expertise for the activity and consult experts during this process
- Keep a log or calendar of your involvement and time spent in the activity
- Maintain separate bank account(s) for the activity
- Maintain separate books and records for the activity
- Create a detailed written business plan with annual budgets and projections (often created when outside financing is involved — an excellent resource is the UC Davis Agricultural and Resource Economics current cost of return studies for wine grapes)
- Document changes in operating methods
It’s also important to note that conducting an activity via a pass-through entity, such as a partnership, Limited Liability Company or an S Corporation will not protect against hobby loss rules. These entities are all subject to the same stipulations and should adhere to the same cautions listed above.
Having fun at your job doesn’t make it a hobby
Especially in industries like wine, a taxpayer may both seek profit for their craft as well as enjoy the process along the way. While the taxpayer may hope to generate a profit, they may also enjoy the activity for recreation or leisure. Receiving gratification from an activity does not in itself make the activity “not for profit.” It is of course perfectly acceptable to find pleasure in one’s business endeavors, but make sure that the activities are separate and well documented in the case of an audit.
Do you have questions about the hobby loss rules?
While the hobby loss rules were originally adopted to curtail the deduction of farm hobby losses, the rules are applied to a wide variety of activities and industries. While enjoying your job should not affect your taxes, it is important to understand where the lines are drawn and how to avoid a scuffle with the IRS down the road. If you have any questions about hobby loss rules or how your business may be affected, feel free to contact one of our winery and agriculture specialists.