You can earn money without being in business. Many people do this (or try to) by engaging in personal investing—for example, by earning interest on personal bank accounts or investing in stocks that pay dividends and appreciate in value over time. Activities like these—that are pursued primarily for profit but aren’t businesses—are called income-producing activities. They are neither businesses nor hobbies, and they receive their own special income tax treatment. The distinction between a business and an income-producing activity is crucial because income-producing activities generally receive less favorable tax treatment than businesses. Thus, you’ll want to avoid this classification whenever possible.
Tax Consequences of Income-Producing Activities
You are entitled to deduct the ordinary and necessary expenses you incur to produce income, or to manage property held for the production of income—for example, real estate rentals. (IRC Sec. 212.) This includes many of the same expenses that businesspeople are allowed to deduct. For example, a person with a real estate rental may deduct maintenance and repair costs; an investor in the stock market may deduct fees for investment advice or accounting services.
However, there are some crucial limitations on deductions for income-producing activities that do not apply to businesses, including:
- No home office deduction. You can’t take a home office deduction for an income-producing activity. This important deduction is available only for businesses conducted from home. You can, however, still depreciate the cost of equipment and furniture that qualify as ordinary and necessary expenses for your activity.
- No Section 179 expensing. Taxpayers engaged in income-producing activities can’t take advantage of Section 179 of the tax code. (Section 179 allows businesspeople to deduct a substantial amount of long-term asset purchases in a single year—$500,000 in 2012 and 2013).
- No seminar or convention deductions. People with income-producing activities can’t deduct their expenses for attending conventions, seminars, or similar events. Thus, for example, you can’t deduct the cost of attending a stock market investment seminar.
- Limit on deducting investment interest. Interest paid on money borrowed to make an investment is deductible only up to the amount of income you earn from the investment. If you earn no income from the investment, you get no deduction. In contrast, interest on money you borrow to use for a business is fully deductible.
- No deduction for start-up expenses. You get no deduction at all for expenses incurred to start up an income-producing activity. Businesses, on the other hand, can deduct $5,000 of their start-up expenses for the first year they are in business, with any excess deductible over 15 years.
- Limit on deductions. Expenses incurred from an income-producing activity (investing, for example) are miscellaneous itemized deductions. That means you can deduct them only to the extent they exceed 2% of your adjusted gross income—the same standard used for hobbies. If all your itemized deductions don’t exceed the standard deductions, you can’t itemize and you get no deduction at all. The only exception is for rents or royalties earned as part of an income-producing activity. With rent and royalty income, you can deduct your related expenses directly from your gross income (just like business expenses). Thus, landlords who earn rent but don’t qualify as businesspeople may still fully deduct their expenses. Royalties include income from things like copyrights or patents, or mineral leases.
No self-employment tax. One positive tax effect of having an income-producing activity instead of a business is that you don’t have to pay any self-employment tax on the income from the activity. Only people in business have to pay self-employment taxes. This is a substantial savings, because the self-employment tax is 15.3% of your net self-employment income, up to an annual ceiling amount.
When you have an income-producing activity, you don’t file an IRS Schedule C, Profit or Loss From Business, with your tax return. You don’t have a business, so that schedule doesn’t apply. Instead, you list your expenses on Schedule A, Itemized Deductions. However, if your income comes from real estate or royalties, you list your income and expenses on Schedule E, Supplemental Income and Loss. Investors who incur capital gains or losses must file Schedule D, Capital Gains and Losses.
Only individuals can deduct expenses from income-producing activities. Corporations, partnerships, and limited liability companies cannot deduct these expenses.
Types of Income-Producing Activities
An income-producing activity is an activity you do primarily to earn a profit, but doesn't involve your active, continuous, and regular management or control of a business.
Personal investing is by far the most common income-producing activity. Investing means making money in ways other than running a business—for example:
- You put your money in a bank and earn interest.
- You buy stocks, bonds, or other securities in publicly traded corporations and earn money from dividends or from the securities’ appreciation in value over time.
- You buy commodities like gold or pork bellies and earn money from their appreciation in value over time.
- You buy real estate and earn money from rents or appreciation in the property’s value over time.
- You purchase an interest in a privately owned business run by someone else and earn money from the increase in the business’s value over time or payments from the business.
What all these activities have in common is that you are not engaged in the active, continuous, and regular management or control of a business. You are passive—you put your money in somebody else’s business and hope your investment will increase in value due to their efforts, not yours. Or, you buy an item like gold and then sit and wait for it to increase in value.
Personal investing is always an income-producing activity for tax purposes, not a business. It makes no difference whether you invest from home or an outside office.
Although the most common, investing is by no means the only income-producing activity. Almost any activity can qualify if your primary motive for engaging in it is to make money but you don’t work at it enough for it to rise to the level of a business. For example, raising and selling horses or buying and selling rare coins could be income-producing activities. You must work continuously and regularly at the activity for it to be a business.