Artists and the Hobby Loss Rule
Individuals who are engaged in creative pursuits often maintain other employment to supplement their income. For example, a painter might work full-time as an art teacher or college professor, or may moonlight as a theater stagehand. Many artists also slog away in professions completely unrelated to their creative endeavors. Nevertheless, they may devote evenings, weekends and summers to making, promoting and selling their art, thus running a business enterprise apart from their “day job.”
However, these individuals may find themselves owing thousands of dollars to the IRS should their creative business pursuits be classified as merely a “hobby.”
This happened to Susan Crile, a painter and multimedia arts whose works have been displayed in top museums like the Metropolitan Museum of Art and the Guggenheim. Susan’s art business came into question with the IRS because she is also a tenured professor of studio art at Hunter College.
Since well before obtaining her teaching position, Susan devoted a substantial amount of time and money earning a living primarily as an artist. In addition to the costs of supplies and studio space, it took a great deal of promotional efforts to have her pieces noticed by curators and art dealers and to be displayed all over the world. Through such efforts over 40-plus years, Susan was able sell 356 works to art collectors and buyers, including a number of large corporations like AT&T, Exxon-Mobile, Bank of America and Charles Schwaab. These successes sustained her business to some degree, but not enough to provide for Susan’s living expenses entirely. Her teaching career filled that need, but as a dedicated artist, she has always continued to put in the time at her business.
Like countless artists before her, Susan wrote off expenses related to her making and selling art on her personal income tax returns. Such expenses included supplies, travel, the costs of reaching out and maintaining communications with galleries and collectors, and hiring assistants to help with social media.
Unfortunately, in 2010 the IRS accused Susan of underpaying her taxes by more than $81,000 from 2004 to 2009 because it claimed her efforts as an artist were not a separate profession or business, and not something she intended to make money from, but something she did as part of her job at Hunter.
To make this argument, the IRS invoked a set of tax code provisions often called the “Hobby Loss Rule.” Under Section 162 of the Internal Revenue Code, a taxpayer is allowed deduct all of the ordinary and necessary expenses of carrying on a “trade or business.” However, the taxpayer must show that he or she is engaged in the activity with an actual and honest objective of making a profit. If an activity is not engaged in for profit, it is a “hobby” under the meaning of Section 183.
The kicker of the Hobby Loss Rule is actually when a taxpayer loses money. Taxpayers can deduct expenses of a “trade or business” in excess of earnings, thus allowing them to claim a net loss. A “hobby” may only deduct its expenses to the extent of the profits of the activity, and cannot generate a net loss. In other words, net losses from a hobby may not be used to offset income from other sources, like a professor’s salary, but net losses from a trade or business can.
Susan’s 2004 through 2009 tax returns reported earnings from sales of her artworks on her Schedule C, but also reported a number of expenses that ultimately resulted in large overall losses for her art business, which she then used to offset other income.
When the IRS looks at whether a taxpayer’s enterprises is a “trade or business” or a “hobby,” a number of factors are considered:
- The manner in which activities were carried on;
- The expertise of taxpayer or her advisers;
- The time and effort the taxpayer expended on the activities;
- The expectation that assets may appreciate in value;
- The taxpayer’s success in carrying on other similar or dissimilar activities;
- The taxpayer’s history of income or loss; and
- The taxpayer’s personal motives.
Accordingly, Susan’s attorney stated that her goal was to show the tax court that “art is not a business like other businesses.” During trial, she called a number of art industry experts, including the dean of the Yale School of Art, Robert Storr, and a 40-year curator, gallery director, and art dealer, Renato Danese.
These experts explained that an art career, and the prices for which an artist can sell his or her work, can be highly volatile. They explained it is not uncommon for artists to make no money for years at a time, and so it is reasonable for artists to have other jobs or careers apart from their own art businesses.
In October 2014, the Tax Court Judge finally made a determination, and it was hailed as a victory to artists everywhere. Judge Albert G. Lauber held that Susan had met her burden of proving that her activities as an artist carried her actual and honest objective of making a profit, and therefore under tax law, should be considered a professional artist entitled to report her full losses on her Schedule Cs.
Despite Susan’s success, artists and creators are wise to still be wary when it comes to the Hobby Loss Rule. Under Sections 162 and 163, there remains a fuzzy line between a hobby and a business venture, especially when taking all the 7 factors outlined above into consideration of a particular creative industry. A tax advisor or attorney familiar with these nuances can help you distinguish between the two and ensure you are compliant with tax laws. If the IRS initially disagrees, a tax professional can also help you work with the IRS to support and substantiate your positions.