The Hobby Loss or Business? The Case of the Amateur Artist
Emma is a full-time high school teacher with a salary of $60,000. She also creates and sells pottery at local craft fairs. In 2025, her pottery activities generated $8,000 in gross receipts and incurred $15,000 in expenses (materials, booth fees, travel). She has been doing this for three years, and each year she has reported a loss. She works on pottery about 20 hours per week during the school year and more in the summer. She has a separate studio, a business bank account, and a website. She keeps detailed records. She has never made a profit, but she believes she will in the future as she gains recognition. She wants to deduct the $7,000 loss against her teaching income. The IRS may challenge this as a hobby under IRC §183. Emma is in the 22% tax bracket.
1. What factors should be considered in determining whether Emma's pottery activity is a business or a hobby?
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Under IRC §183 and the regulations, the determination of whether an activity is a business or hobby is based on all facts and circumstances. The nine factors from Reg. §1.183-2(b) are: 1) Manner in which the taxpayer carries on the activity (businesslike manner, separate books, business bank account, website). 2) Expertise of the taxpayer or advisors (she may have some expertise). 3) Time and effort expended (20 hours per week is substantial). 4) Expectation that assets may appreciate in value (pottery equipment may appreciate? Not likely). 5) Success in carrying on other similar activities (she has no other business). 6) History of income or losses (three years of losses). 7) Amount of occasional profits (none yet). 8) Financial status of the taxpayer (she has a steady salary, so the activity is not her main source of income). 9) Elements of personal pleasure or recreation (pottery can be enjoyable). No single factor is determinative. The fact that she has a separate studio, business bank account, website, and keeps detailed records suggests a business. However, the continued losses and the fact that she has a full-time job may indicate hobby. The IRS may argue that she lacks a profit motive. Emma should consider making an election under §183(e) to defer the hobby loss determination? Actually, §183(e) allows a taxpayer to elect to postpone the determination for any activity that has not been profitable for at least three years. But that election is for the IRS to determine? No, §183(e) is for the taxpayer to elect to have the activity treated as a business for a period, but it requires that the activity has been conducted for at least 3 years and the taxpayer elects to defer the determination. However, the election is not available if the activity is not a business? Actually, §183(e) allows a taxpayer to elect to treat an activity as a business for a specified period, but it's complex. More practically, Emma should document her profit motive and consider whether she can demonstrate a reasonable expectation of profit. She might also consider the safe harbor for profit motive under §183(d): if the activity is profitable in at least 3 out of 5 consecutive years (or 2 out of 7 for horse activities), it is presumed to be a business. Since she has losses, she cannot use that presumption. She could restructure her activities to be more businesslike, such as creating a business plan, separate advertising, etc. Ultimately, if the IRS challenges, she would need to prove profit motive. The loss would be deductible only if she can show a profit motive. Otherwise, expenses are deductible only up to gross income, and the excess is not deductible. So she would lose the $7,000 deduction.
2. If Emma's activity is deemed a hobby, how would her deductions be treated, and what is the tax impact compared to if it were a business?
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If the activity is a hobby, under IRC §183, deductions are allowed only to the extent of gross income from the activity. The deductions are taken in a specific order: first, expenses that would be deductible regardless of whether the activity is a business (e.g., state and local taxes, home mortgage interest) are deductible in full (but not subject to the 2% AGI floor). Second, expenses that increase basis (e.g., depreciation) are deductible up to gross income. Third, other expenses (e.g., supplies, booth fees) are deductible up to remaining gross income. However, for tax years 2018-2025, miscellaneous itemized deductions subject to the 2% AGI floor are suspended, so hobby expenses are not deductible at all unless they are deductible under another provision. Therefore, for 2025, hobby expenses are not deductible. So Emma would report $8,000 of hobby income on her return (likely as other income), and no deductions. Her taxable income increases by $8,000, resulting in additional tax of $8,000 * 22% = $1,760. If the activity is a business, she would report $8,000 gross income and $15,000 expenses, resulting in a $7,000 loss, which reduces her taxable income by $7,000, saving $7,000 * 22% = $1,540. The difference between hobby and business treatment is $1,760 + $1,540 = $3,300 in tax. Additionally, if it's a business, she may be subject to self-employment tax on net earnings (but since it's a loss, no SE tax). If hobby, no SE tax. Also, if business, she could deduct expenses even if they exceed income, but if hobby, she cannot. So the tax impact is significant.