For years individuals have expanded a hobby into a successful full-time business that supports themselves and their families. Others merely fill their leisure hours with a hobby that is fun and gives great enjoyment. However, there is also that in-between stage where the sale of items produced in leisure time causes income tax problems that taxpayers need to be aware of.
Whether you bake wedding cakes in your kitchen for friends and relatives or make wood lawn silhouettes and take them to a flea market and sell them, you have gross income that belongs in your Federal (and state, where applicable) income tax return. Whether or not you can claim the expenses that are associated with making the cakes and lawn silhouettes depends on a number of factors.
You'll need to determine if the item you are selling provides you with a living or is intended to be profitable. One factor the IRS considers when making that determination is if you carry on the activity in a business-like manner. If so, do you maintain a separate bank account, have a specific name for the business, keep books, have a business license, have separate telephone lines (if the business is operated in your home), and do you advertise or promote your business? Another factor is the amount of time and effort you put into the activity to make it profitable. Time is measured not only in the making of the product but also in marketing your product.
Is there an intent to have a profitable business? Do you depend on the income from the activity for your livelihood? Have you had a profit from this hobby in the past or are the losses getting smaller? If there are losses, are they attributable to normal start-up expenses or are they due to other circumstances?
Other considerations include your level of expertise in the "hobby" activity. Are you self-taught, do you have formal education, or are you certified by a professional group who has tested you?
If your answers indicate you are not operating the hobby as a business, the manner in which your expenses can be claimed is very different from those who are operating a business. (A regular business reports the net income [sales minus expenses] on its tax return.) If you have sales and expenses from a hobby activity, you report those items on your individual tax return as follows:
Gross sales are included on Line 21 of Form 1040. Expenses attributable to the hobby activity are deductible up to the amount of gross income from the hobby on Schedule A (Form 1040) as miscellaneous itemized deductions. But you also need to remember that these miscellaneous deductions are reduced by 2% of your adjusted gross income with the resulting amount being the deductible amount. Further, you need to be able to itemize your deductions. So, if you are single, your itemized deductions need to exceed $4,750 (in 2003) before there is a benefit to itemizing. In the end, your hobby expenses may not be deductible after all.
Let's look at an example. Tom, who is single makes wood lawn silhouettes and takes them to a flea market to sell. The activity is done in the evenings and on the weekends from May to September. He has no workshop at his home but works in the backyard or the patio. During the day, Tom is a computer programmer and works 50 hours a week at this job that earns him a salary of $45,000. He pays $15 each time he sets up a spot at the flea market to sell the finished items.
From May to September he went to the flea market six times with the silhouettes and sold 25 of the 30 he had available for a gross amount of $1,375. Given just these facts, it is fairly apparent that Tom's regular job is his livelihood and that he puts in a small - and not regular - amount of time on his hobby. Because he can only work outdoors, unless he rents an enclosed working space, it is unlikely that he will develop his hobby into a full-time business any time in the near future. So how does Tom report the income and expenses on his income tax return?
First, the $1,375 is reported on Line 21 of Form 1040 as "hobby income." Next, Tom must gather his receipts for the expenses attributable to the hobby activity. He has the following expenses to report:
The cost of the saw, sander, and sawhorses is not deductible since the items were also used for personal use and not exclusively for the hobby activity. And ditto for the electricity - there was a mix of personal and non-personal, which cannot be accurately measured. If you use 36 cents a mile for mileage, Tom's mileage deduction is $65 (rounded). Therefore, he has total allowable expenses of $935 ($625 + 155 + 90 +65). These expenses are reported on Schedule A, miscellaneous itemized deductions.
Tom's adjusted gross income from Line 31 of his Form 1040 is $46,375 (salary of $45,000 and gross hobby income of $1,375). Therefore, 2% of that amount is $928 (rounded). If Tom has no other miscellaneous itemized deductions, the total amount allowed for hobby expenses would be $7 ($935 in expenses minus $928 for the 2% adjustment). That $7 is added to Tom's other itemized deductions to determine if he meets the threshold to itemize or not. Assuming Tom is able to itemize his deductions, the net effect of the expenses he incurred to make the lawn silhouettes is a $7 deduction against $1,375 gross sales, even though his receipts show over $1,200 in expenses before mileage and electricity.
If we change the numbers a little and Tom's expenses were $1,450, he would be limited to $1,375 as the amount to report on Schedule A as hobby expenses, since he cannot claim more expenses than the gross sales from the activity.
Are you in a similar situation as Tom? Do you believe your business is profit-motivated? There are a lot of factors to consider when determining deductibility of expenses connected with sales of items made in leisure or hobby time. Call Tax Matters to talk about how your specific situation affects your income tax.
Lumber for 25 silhouettes sold (not the 30 actually made)
25 sheets plywood @ $25 = $635
Screws, nails, wood glue, tracing paper, patterns purchased, paint = $155
New scroll saw, orbital sander, and sawhorses bought to make the silhouettes (but he also used the sander and sawhorses when he repaired a door in his basement that was warped from a broken hot water heater and the scroll saw was used to make some lattice for his patio) = $340
Flea market fees - 6 times @ $15 = $90
Mileage to lumber yard to purchase supplies & mileage to flea market - 181 total = ???
Electricity to operate saw, sander, and lights at home = ???
Whether you bake wedding cakes in your kitchen for friends and relatives or make wood lawn silhouettes and take them to a flea market and sell them, you have gross income that belongs in your Federal (and state, where applicable) income tax return. Whether or not you can claim the expenses that are associated with making the cakes and lawn silhouettes depends on a number of factors.
You'll need to determine if the item you are selling provides you with a living or is intended to be profitable. One factor the IRS considers when making that determination is if you carry on the activity in a business-like manner. If so, do you maintain a separate bank account, have a specific name for the business, keep books, have a business license, have separate telephone lines (if the business is operated in your home), and do you advertise or promote your business? Another factor is the amount of time and effort you put into the activity to make it profitable. Time is measured not only in the making of the product but also in marketing your product.
Is there an intent to have a profitable business? Do you depend on the income from the activity for your livelihood? Have you had a profit from this hobby in the past or are the losses getting smaller? If there are losses, are they attributable to normal start-up expenses or are they due to other circumstances?
Other considerations include your level of expertise in the "hobby" activity. Are you self-taught, do you have formal education, or are you certified by a professional group who has tested you?
If your answers indicate you are not operating the hobby as a business, the manner in which your expenses can be claimed is very different from those who are operating a business. (A regular business reports the net income [sales minus expenses] on its tax return.) If you have sales and expenses from a hobby activity, you report those items on your individual tax return as follows:
Gross sales are included on Line 21 of Form 1040. Expenses attributable to the hobby activity are deductible up to the amount of gross income from the hobby on Schedule A (Form 1040) as miscellaneous itemized deductions. But you also need to remember that these miscellaneous deductions are reduced by 2% of your adjusted gross income with the resulting amount being the deductible amount. Further, you need to be able to itemize your deductions. So, if you are single, your itemized deductions need to exceed $4,750 (in 2003) before there is a benefit to itemizing. In the end, your hobby expenses may not be deductible after all.
Let's look at an example. Tom, who is single makes wood lawn silhouettes and takes them to a flea market to sell. The activity is done in the evenings and on the weekends from May to September. He has no workshop at his home but works in the backyard or the patio. During the day, Tom is a computer programmer and works 50 hours a week at this job that earns him a salary of $45,000. He pays $15 each time he sets up a spot at the flea market to sell the finished items.
From May to September he went to the flea market six times with the silhouettes and sold 25 of the 30 he had available for a gross amount of $1,375. Given just these facts, it is fairly apparent that Tom's regular job is his livelihood and that he puts in a small - and not regular - amount of time on his hobby. Because he can only work outdoors, unless he rents an enclosed working space, it is unlikely that he will develop his hobby into a full-time business any time in the near future. So how does Tom report the income and expenses on his income tax return?
First, the $1,375 is reported on Line 21 of Form 1040 as "hobby income." Next, Tom must gather his receipts for the expenses attributable to the hobby activity. He has the following expenses to report:
The cost of the saw, sander, and sawhorses is not deductible since the items were also used for personal use and not exclusively for the hobby activity. And ditto for the electricity - there was a mix of personal and non-personal, which cannot be accurately measured. If you use 36 cents a mile for mileage, Tom's mileage deduction is $65 (rounded). Therefore, he has total allowable expenses of $935 ($625 + 155 + 90 +65). These expenses are reported on Schedule A, miscellaneous itemized deductions.
Tom's adjusted gross income from Line 31 of his Form 1040 is $46,375 (salary of $45,000 and gross hobby income of $1,375). Therefore, 2% of that amount is $928 (rounded). If Tom has no other miscellaneous itemized deductions, the total amount allowed for hobby expenses would be $7 ($935 in expenses minus $928 for the 2% adjustment). That $7 is added to Tom's other itemized deductions to determine if he meets the threshold to itemize or not. Assuming Tom is able to itemize his deductions, the net effect of the expenses he incurred to make the lawn silhouettes is a $7 deduction against $1,375 gross sales, even though his receipts show over $1,200 in expenses before mileage and electricity.
If we change the numbers a little and Tom's expenses were $1,450, he would be limited to $1,375 as the amount to report on Schedule A as hobby expenses, since he cannot claim more expenses than the gross sales from the activity.
Are you in a similar situation as Tom? Do you believe your business is profit-motivated? There are a lot of factors to consider when determining deductibility of expenses connected with sales of items made in leisure or hobby time. Call Tax Matters to talk about how your specific situation affects your income tax.
Lumber for 25 silhouettes sold (not the 30 actually made)
25 sheets plywood @ $25 = $635
Screws, nails, wood glue, tracing paper, patterns purchased, paint = $155
New scroll saw, orbital sander, and sawhorses bought to make the silhouettes (but he also used the sander and sawhorses when he repaired a door in his basement that was warped from a broken hot water heater and the scroll saw was used to make some lattice for his patio) = $340
Flea market fees - 6 times @ $15 = $90
Mileage to lumber yard to purchase supplies & mileage to flea market - 181 total = ???
Electricity to operate saw, sander, and lights at home = ???