Can You Take Deductions for Your Hobby Business?
These days, many U.S. taxpayers have a side gig they use to supplement their income and pursue their passions. Sometimes, these activities can come with significant expenses. You may wonder whether creating a business entity will provide tax relief. The question becomes whether you can take deductions for your hobby business.
Wealthy Family Creates New Business to Raise Miniature Donkeys
William Huff, an investment accountant, and his wife Cathy Huff, an attorney, spent decades building up their family’s wealth. W.R. Huff Asset Management Co, LLC, Mr. Huff’s primary business, invested money on behalf of high net worth individuals, and managed money for pensions, profit-sharing plans, endowments, foundations, and government entities. In 2005, Forbes estimated their net worth at $750 million.
But the Huffs’ daughter, Jennifer, had different priorities. Her father helped her found a dog grooming business with moderate success. She and her husband lived on a farm in New Jersey, maintaining a relatively modest lifestyle. Mr. Huff wanted more for her.
He started a new business, Ecotone, which was organized for “agricultural and equestrian or equine purposes including, without limitation, breeding and raising animals.” The animals in question were miniature donkeys. By mid-2010, Huff had created a plan to assemble a herd of miniature donkeys with attractive and profitable genetic attributes (mostly being small and cute) that would become self-perpetuating. He planned to establish the business and, once it became profitable, turn it over to Jennifer so she could earn money from the sale of the diminutive donkeys.
Unfortunately, breeding pint-sized equines turned out to be more difficult and less profitable than Mr. Huff imagined. Since the goal was to breed the animals as small as possible, some foals were delivered stillborn or with genetic deformities. In addition, the Court noted:
“Moreover, some donkeys of smaller stature were simply uninterested in the pleasures of the flesh, complicating the breeding process.”
In addition, the farm had some deaths within the herd due to the cold New Jersey winters. This required additional investments into the business, such as electrifying the sheds and increasing the frequency of feedings to keep the donkeys’ metabolism up and their temperatures warmer.
Ultimately, the prices Ecotone paid to build their herd and the costs of maintaining them far outweighed the income made by selling them. Between 2010 and 2018, Ecotone bought 25 donkeys at a cost of $92,985 and sold 20 donkeys for only $23,500. As a result, they reported losses of between $21,000 and $88,000 each year.
IRS Disallows Half-Ass Deductions for Miniature Donkey Breeding Farm
These losses caught the IRS’s attention. The IRS audited the Huffs income tax returns, including the loss deductions taken for the miniature donkey breeding business. The auditor decided that Ecotone was not carrying on a trade or business, so the Huffs could not deduct their losses on the purchase, care, maintenance, and sale of the donkeys. Excluding those deductions, the IRS assessed the Huffs deficiencies for $37,022 in 2013 and $19,615 in 2014, along with more than $11,000 in accuracy-related penalties over the two years. The Huffs sued the IRS in the U.S. Tax Court to have that deficiency overturned.
Hobby Business vs For-Profit Venture: It Matters for Tax Deduction Purposes
Taxpayers are generally allowed to deduct all ordinary and necessary business expenses they incur in the course of carrying on their business. However, they may not deduct expenses for sports, hobbies or recreational activities. The difference between a hobby business and a for-profit venture depends on whether the activity was “engaged in for profit.” That means in order to deduct expenses for an activity, you must have gone into the activity hoping to make money off it. The expectation of profit doesn’t have to be reasonable, but you must have started and continued the activity with the goal of earning money from it.
The Factors for Whether a Business is For-Profit
Your intent to make money doesn’t have to be reasonable, but it does need to be observed objectively. In other words, you must treat your business like you mean for it to make money. To determine whether an activity is a for-profit venture or merely a hobby business, tax courts consider 9 factors:
- The manner in which you carry on the activity
- Your expertise and use of advisors
- Time and effort put into the activity
- Your expectation that assets will appreciate in value
- Your success in other business activities
- Your history of income or loss regarding the activity
- The amount of occasional profits from the activity
- Your financial status
- Elements of personal pleasure or recreation
All these factors must be considered together to distinguish between a hobby business, where income simply offsets the costs of the pleasure activity, and a business being operated for profit.
Was Donkey-Breeding a Hobby Business?
The U.S. Tax Court noted that equine breeding is an activity that often skirts the line between hobby business and for-profit venture. It quoted a 2009 case, Helmick v Commissioner, saying:
“The ‘stereotypical abusive scenario involving horse breeding is the wealthy businessman who runs a real business during the week * * * and owns a “gentleman’s farm” as a weekend retreat where he keeps horses for the recreation of himself and his family and friends.’”
Dabbling in breeding horses, or in this case donkeys, without the expectation of profit does not allow the business owner to deduct the expenses of those horses and “have Uncle Sam subsidize the weekend farm.”
However, after evaluating each of the nine factors, the Court found that the Huffs had “entered into the breeding activity with the dominant hope and intent of making a profit.” Specifically, the Court was convinced that Huff went into the donkey-breeding business not out of a “late-discovered passion for adorable little animals,” but out of concern for his daughter’s earnings. It therefore found Ecotone to be a for-profit business, and overturned the donkey deductions deficiencies. The Court ruled in favor of the taxpayers and cancelled the accuracy-related penalties assessed by the IRS.
As the factors above demonstrate, the line between a hobby business and a for-profit venture can be hard to see. If the costs of your side gig or passion project are beginning to grow, you should discuss the nature of the business, and how you manage it, with an accountant or tax attorney before you claim deductions on your hobby business’s expenses. Otherwise, you could get a mule-kick of a surprise if the IRS decides your deductions were only half-assed.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you are facing an IRS audit over your hobby business’s deductions, contact Joe Viola to schedule a free consultation.