Hobby or Business? A Discussion on Filing U.S. Form Schedule C

Self-employed U.S. taxpayers file a Form Schedule C Profit or Loss from Business along with their Form 1040 in order to report activity from sole proprietorship businesses. Schedule C allows taxpayers to report earnings or losses from a sole proprietorship and pay related income and self-employment taxes at the individual level. The net income will increase the taxpayer’s overall taxable income and be subject to income tax or, if a loss is generated, offset other income at an ordinary rate. A loss situation potentially allows taxpayers to reduce their income tax liability from other sources.

Due to losses from self-employment being permitted to reduce taxable income, such losses are scrutinized by the IRS to determine business purpose and to ensure the losses are a result of a business and not a mere hobby. Recently, a taxpayer was found by the U.S. Tax Court to have substantially understated his income by claiming business expenses for an activity the IRS deemed to not have a profit motive. In Allen T. Stettner and Julie A. Stettner v. Commissioner, Allen Stettner (Stettner), a racing enthusiast, created AJS Motorsports in 2011 and reported income and expenses on his Schedule C. The primary source of income for AJS Motorsports was the sale of used car parts, not the winning of races. Stettner claimed to be in business for a profit and considered himself an expert through his 20 years of being in the racing industry.

Nearly $80,000 of combined net losses were reported on Stettner’s 2011 and 2012 Schedule C forms. Stettner did not have a formal business plan or a separate bank account to establish AJS Motorsports as a for-profit company. While unemployed in 2011, Stettner was able to devote more than 40 hours per week to the business; however, this number was reduced dramatically after he became employed in 2012.

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This was not Stettner’s first attempt at filing a Schedule C. In 2006 and 2007, he reported income and expenses from Al Stettner Racing, amounting to net losses of $19,991 and $16,641 respectively.

The issue at hand falls under IRS Code Sec. 183 Hobby Expenses and Losses. The IRS takes into consideration nine factors when making a determination about whether an activity is engaged in for profit, including:

1. The manner in which the taxpayer carries out the activity.
2. The expertise of the taxpayer or his/her advisors.
3. The time and effort expended by the taxpayer in carrying out the activity.
4. The expectation that assets used in the activity may appreciate in value.
5. The success of the taxpayer in carrying out other similar or dissimilar activities.
6. The taxpayer’s history of income or losses with respect to the activity.
7. The amount of occasional profits, if any, which are earned.
8. The financial status of the taxpayer.
9. The elements of personal pleasure or recreation.

Stettner was able to satisfy just two of the above points (3 and 8). He did not maintain accurate books and records, and did not adopt any new techniques when the business was unprofitable. The company also did not operate with a business plan; the court opinion stated that business operations would necessarily involve a business plan. Accordingly, the IRS found AJS Motorsports an activity not engaged in for profit. It was determined that Stettner would have to pay $12,705 in taxes and $2,541 of accuracy-related penalties.

If you operate a sole proprietorship and have questions about profitability or how the IRS classifies hobbies regarding Schedule C, please call your Marcum Tax Advisor.