Now I have all sorts of advice about moving from a hobby to a business, but in this case, things might be a little different. The reason I say that is because baseball cards are collector’s items. It kind of depends what level the gentleman is at. You can buy cards and sell them at retail of course, that would be a regular business. But there are also the folks that buy and trade “collectibles”. The recent auction price of a Honus Wagner card for $262,000 gives you a clue as to what I’m talking about.
If your business or hobby involves selling collectible items, such as art, guns, coins, stamps, and things like that, you might be reporting your income on a schedule D form. The same form that you use to report gains and losses from the sale of stocks, bonds, and mutual funds.
I like reporting income that way because of the tax advantage, there’s no self employment tax and if you sell an item that you’ve held for over a year then you’re also taxed at the lower capital gains tax rate. The downside to reporting this way is that you get no loss deduction for the sale of “capital assets held for personal use.”
There could be three possible ways to report the same income for a “hobby/business/capital gain” sale. For example: Let’s say you purchase a painting for $1,000. You keep it in your living room for a few years and then you sell the painting for $2,000. If you report the income as a hobby: $2,000 goes on line 21 of your 1040 and you might be able to claim the $1000 you paid for the painting as a deduction on your Schedule A, (but because of the other rules involved, most like you won’t get to deduct that at all.) If you’re in the 25% tax bracket, you’ll pay $500 more in income tax. If you report the $2,000 as self employment income on Schedule C, you can deduct the $1000 as an inventory expense leaving you with a profit of $1,000. Taxed at 25%, that’s $250. Add to that the 15% self employment tax which adds another $150 making your tax bill $400. As a sale of a capital asset, you report on schedule D the income of $2,000, the basis of $1,000 with a taxable long term capital gain of $1,000 which will be taxed at the capital gain rate of 15% costing you $150 of tax money. In this example, I know I’d want to use the capital gain.
Of course, there are other rules and issues you have to consider when determining if an activity is a hobby or business or collection, but the example above does let you see some of the differences in how you might want to structure your business/hobby/collection.
I’d have to ask the baseball card fellow some more questions about his business plan to determine exactly what category I’d place him in. But with some collectors, it’s pretty obvious that you’d want to classify their collecting income as capital gain and not self employment.
Filed under: Self Employed, Tax Deductions, Uncategorized
Batman stopped by my office the other day. He usually doesn’t visit me in his Bat costume, but he had just done a charity fundraiser as Batman and had promised the ladies in my office to visit us in costume. (I’d just like to point out that not all of my friends and clients are super heroes. I do know plenty of normal people.)
I recently did a post about a fellow who made a business out of appearing as Superman. On a good day, Superman can take in some decent money. After Batman’s successful fundraiser, he kind of wondered aloud about following in Superman’s footsteps and making occasional appearances for pay also. While I recently made the case for Superman being a legitimate business, Batman’s income I believe would be a hobby.
How do you tell if something is a business or a hobby? Sometimes it’s kind of hard to tell. Everybody recognizes that if you open up an Ace Hardware store selling tools and duct tape you’ve got yourself a real business. But what if you make purses and wallets out of duct tape and sell them at craft fairs? Where does that fit in? What if you breed your champion Cocker Spaniel and sell the puppies? Dog breeding is a real business, but how many litters makes you a breeder? It’s not all black and white. Here are some guidelines to help you.
First, I want to point out the most important key ingredient that the IRS uses to determine if you are a real business: a 1099MISC showing an amount under “non-employee compensation.” There are numerous guidelines as to what constitutes a business versus a hobby and this one is never mentioned. Yet it’s the most important factor as far as the IRS is concerned! If you receive a 1099MISC, the IRS counts that as self-employment and they will tax you not just income tax, but an additional 15% self employment tax. As a professional preparer, if I see one of those, even if I truly believe that your business should be classified as a hobby, I’m preparing a Schedule C showing you as a business. That’s how the IRS is treating that income.
What’s the difference in how your income is classified and why is it important? Business income is taxed at your regular income tax rate plus the self employment tax rate. Let’s say your regular tax rate is 25%, then your business income is taxed at 40% (25% + 15% = 40%.) The advantage of being treated as a business is that you can write off your direct business expenses against the income and you can even have a loss that will offset your other income. Hobby income is taxed at your regular tax rate, there is no self employment tax so you pay less tax on hobby income. The disadvantage is that although you can write off expenses against your hobby income, you can never take a loss. Also, for many people, the hobby expense write off is a worthless deduction. (It goes on the Schedule A under miscellaneous deductions subject to the 2% limitation rules.)
You cannot switch your business back and forth from hobby to business depending upon whether or not you have a profit or loss. It’s okay to grow your hobby into a business. It’s even okay to downgrade your business into a hobby. But flip flopping for the sake of lowering your taxes is just going to land you in trouble with the IRS. You need to put a little thought into it before you start claiming business losses.
If you’re not receiving 1099 MISC forms, what other tests can you use to prove your business is real and not a hobby? One is the three year test–if you’ve shown a profit in three out of the past five years, then you’re considered a business. This is a good rule, but it’s not completely hard and fast. There are court cases proving businesses to be valid even though they’ve shown losses for more than three years. Even though its a good rule of thumb, I don’t like to see people get too hung up on it, there are other tests.
Is the business carried out with the intention to make a profit? Does the taxpayer (or the taxpayer’s advisors) have the knowledge to make the business a success? Does the taxpayer spend enough time on the business to indicate a profit motive? Has the taxpayer made a profit on similar activities in the past? The answers to these questions is why I put Superman in the business category and not the hobby category. Superman had previous paid experience as a costumed character and model, and he also had a website devoted to his business and posted blogs about how to be a superhero. He clearly devotes a great deal of time to his business. Batman,on the other hand, wouldn’t really pass these tests, that’s why I consider his income to be hobby income.
One final point. Batman takes offense at Batman labeled as a hobby. “Batman isn’t a hobby, it’s a calling.” Like I said in the beginning, some of my friends are normal.
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