August 1997

A long-standing IRS rule disallows deductions for losses incurred in pursuing "hobbies." Because of that distinction, the feds program their computers to bounce returns that show full-time salaries and other sources of income offset by losses from sideline ventures that could be hobbies - photography, writing and painting, to cite some of the activities that are likely to draw the attention of the tax collectors.

How does the law determine whether your intention is to turn a business profit from, say, your stock photography, or just to have fun? There are no all-purpose guidelines. The answer depends upon the particular circumstances.

For instance (assuming you receive a salary from a full-time job elsewhere), a string of yearly losses incurred by your side-line photography business usually indicates that your enterprise is nothing more than a hobby. However, bad luck is not necessarily fatal. This point was underscored in a Tax Court decision that allowed losses sustained by Gloria Churchman, an artist who operated in the red for 20 straight years.

But an understanding Tax Court sided with Gloria because she devoted substantial time to her art activities and conducted them in a businesslike manner. Among other things, she kept good records of what was sold, to whom, and continually tried to sell her pictures by exhibiting them and promoting them in other ways, such as by writing books that featured her artworks. When sales faltered, Gloria adjusted and altered her style in efforts to make her work saleable. Her testimony persuaded the court that she was a dedicated artist who craved recognition as an artist and believed she would attain that recognition by deriving a profit from her painting.

The Tax Court approved the disputed deductions because Gloria demonstrated that her track record did show the required intention to make a profit. Conceivably, the court noted, "she may someday sell enough of her paintings to enable her to recoup the losses which have been sustained in the intervening years."

HOBBY OR BUSINESS? Internal Revenue Code Section 183 provides guidelines on how to distinguish between a hobby and a business. To come within the protection of Section 183, you have to establish a profit motive.

There is a presumption that you are engaging in a business with the IRS as your partner, rather than a hobby, if you have a net profit in any three out of the last five consecutive years (two out of seven years if you are involved in the breeding, training, showing or racing of horses).

So, usually, not to worry when you have at least three profitable years during the last four. Satisfy that stipulation and you are entitled to fully deduct your expenses this year, even if this is a loss year.

CAUTION: If you have yet to meet this requirement, you should take steps now to either boost your income from the activity or decrease your expenses. Otherwise, you risk forfeiture of your expenses. Moreover, if you can arrange this year to be your third profitable year out of the four, you will safeguard your deductions for next year.

Editor's Note: Remember, the above 3-out-of-5 year rule applies when your business is a sideline venture, and you or your spouse hold down another, salaried position. If your photography business is your primary business, with decided business intent to make a profit, your losses and expenses each year are accepted by the IRS.

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