Whether an activity is classified as a hobby or business by the IRS has enormous tax consequences. If you’re engaged in a business activity, virtually all of your expenses are deductible. And, if they exceed your income from the business, they may be deducted from other income you have such as salary from a job or investment income. They can be even be deducted from past years taxes you already paid. In contrast, hobbyists can deduct their hobby-related expenses only from the income the hobby generates. If you have no income from the hobby, you get no deduction. And you can’t carry over the deductions to use in future years when you earn income—you lose them forever.
For tax purposes, a business is an activity you engage in primarily to earn a profit. You can enjoy doing it, but enjoyment is not your primary motivation, making a profit is. You don’t have to earn a profit every year—or even for many years—but profit must be the main reason you do the activity.
The IRS commonly classifies inherently “fun” activities like creating art, photography, crafts, writing, antique or stamp collecting, or training and showing dogs or horses, as hobbies, even where the people who do them make money. However, in a big victory for artists, the U.S. Tax Court has held that an artist who never earned a profit was nonetheless engaged in a business.
Like many artists, Susan Crile had a regular day-job—she was a tenured professor of studio art at Hunter College in New York City. However, for over 40 years, she created art in a variety of media that she exhibited and sold through leading galleries. During her career she created more than 2,000 pieces of art, some of which ended up hanging in over 25 museums.
Crile was clearly a highly successful artist. She sold 356 works of art from 1971 to 2013, generating approximately $668,000, after commissions. Her best year was 1995 when she reported gross receipts of $112,000 from art sales. However, she never earned a profit from her art—that is, her annual earnings from art never exceeded her expenses. Thus, the IRS claimed that Crile's art activity was not a business.
In cases like Crile’s where a taxpayer never earned a profit from an activity, the IRS and courts employ a behavior test to determine whether the activity is a business. To do this, they look a number of objective factors to figure out whether the taxpayer behaved as though he or she wanted to earn a profit from the activity, or was doing it for other reasons such as to have fun or obtain tax deductions. These factors include the following:
By far the most significant factor is the manner in which the activity is conducted—that is, whether it is carried on in a businesslike manner. The court noted that Crile kept fairly good (though not perfect) business records, hired a bookkeeper, had a business plan, actively marketed her art, and generally behaved in a professional manner. This factor strongly favored Crile.
People who are in business to make money usually have some knowledge and skill relevant to the business. Crile had significant expertise as an artist. This factor also strongly favored Crile.
The fact that a taxpayer devotes considerable time and effort to an activity helps to indicate a profit motive. Crile spent about 30 hours per week on her art business during the academic year, and worked at it full time during the summer. This factor strongly favored Crile.
An expectation that assets used in the activity will appreciate in value may indicate a profit motive. The Court found that Crile had a reasonable expectation that the value of her art inventory would eventually appreciate significantly. Thus, this factor favored Crile.
Having a track record of success in other businesses—whether or not they are related to the current business—indicates a profit motive in the current business. Crile always worked as an artist, so this factor had little relevance.
The fact that a taxpayer incurs a series of losses beyond an activity’s startup years indicates absence of a profit motive. However, the Court noted that it often takes many years to achieve economic success in the creative arts. Thus, a history of losses is less persuasive in the art field than it might be in other fields. The fact that Crile never earned a profit in 20 years favored the IRS.
Crile never earned a profit from her art during 1971 through 2013. Thus, the Court found that this factor favored the IRS.
The Court found that Crile's art business was her primary activity and that she didn't become an artist to shield her other income from taxes.
The fact that a taxpayer derives personal pleasure from an activity, or finds it recreational, suggests lack of a profit motive. The Court said that it was obvious that Crile enjoyed making art. However, Crile did many things as part of her art activity that were not so fun, such as engaging in extensive research for various art projects (including travelling to Guantanamo Bay), and devoting many hours to the mundane aspects of marketing her art and running her business—for example, she maintained a mailing list of 3,000 collectors; mailed out slides and marketing packets; managed relationships with galleries, maintained invoices, receipts, and other business records; and attended networking events with museum curators and potential collectors. Thus, she devoted to her art activity a level of seriousness that took it well beyond the realm of recreation. Thus, this factor was neutral or slightly favoring Crile.
Since the majority of the factors favored Crile, the court held that her art activity was engaged in primarily to earn a profit and qualified as a business for tax purposes. (Crile v. Comm’r, T.C. Memo. 2014-202.)