Date: Spring 1995

Newsletter of the District of Columbia Bar Arts, Entertainment & Sports Law Section

How are your clients reporting their arts income? Advise them to handle it carefully at tax time, or they could get picked for an audit.

Computers are now used by the IRS to scan for "red flags" -- tax information that will cause the whole tax return to be pulled and assigned to an agent for audit.

What do they search for? Among the tax situations that draw attention are losses from a hobby which are deducted against the taxpayer's regular income.

Frequently, individuals carry on an activity that has no profit motive. The I.R.S. will not classify this as a business. Instead, it will be classified as a hobby, and it will be subject to the so-called "hobby loss" rules: The deductions you can take are limited to the income from the hobby, if any, and no loss is allowed to offset other income.

How is it determined if the artist is engaged in a for-profit business or a hobby?

To determine whether an income-producing activity is carried on for profit, all of the facts with regard to the activity are taken into account.

Among the factors considered are:
· Do you carry on the activity in a business-like manner?
· Does the time and effort you put into the activity indicate you intend to make it profitable?
· Are you dependent on the activity for your livelihood?
· Are your losses from the activity due to circumstances beyond your control, or are they normal in the start-up a for-profit business or phase of your type of business?
· Did you change your methods of operation in an attempt to improve the profitability of the activity?
· Do you, or your advisors, have the knowledge needed to carry on the activity as a successful business?
· Were you successful in making a profit in similar activities in the past?
· Did the activity make a profit in some years, and how much profit did it make?
· Can you expect to make a future profit from the appreciation of the assets used in the activity?

No single answer is decisive. Instead, all the facts are weighed to determine whether the taxpayer is engaged in a activity intending to make a profit someday, or as a hobby.

The easiest way to defuse I.R.S. suspicion that your activity is a hobby and not a business is to show a profit in three of any five consecutive years the I.R.S. reviews. The law states that an activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. The burden then is on the I.R.S. to prove otherwise.

A caveat is appropriate. This profit shouldn't be one dollar, or one hundred dollars, or any other manufactured figure. Manufactured figures are easy to spot in computer checks of tax returns. Make sure the figures in your business books correspond to the figures you enter on your Schedule C and that your profit is real, regardless of its size.