Attorneys, accountants, and many other individuals may conduct activities in addition to their main line of work. These activities may be chartering boats, breeding dogs, selling antiques, or any other manner of business. Some of these sideline activities may be profitable ventures while others run in the red. From a tax perspective, the treatment of income and losses can be good or bad; it all depends.

Profitable Sideline Activities

If a sideline activity generates income after subtracting deductible expenses, the income is taxed in the same way as any other business income; it's ordinary income. Usually, sideline activities are conducted as sole proprietorships, so income and expenses are reported on Schedule C of Form 1040. But there is nothing that prevents a sideline activity from being run through a corporation or limited liability company.

Taxable income can effectively be reduced by contributing to a qualified retirement plan based on profits from the sideline activity. An individual covered by another qualified retirement plan (e.g., one through a legal practice) may still be eligible to receive contributions with respect to the sideline activity. However, contributions limits (e.g., annual cap on elective contributions to 401(k) plans) apply.

Profits from a sideline activity are taken into account in figuring the 20% qualified business income (QBI) deduction to the same extent as a full-time business (Code §199A). Thus, income from a sideline activity increases taxable income, which may limit or bar any QBI deduction for a main activity if that main activity is a specified service trade or business (SSTB). Those providing services through a pass-through entity (e.g., a limited liability partnership) for the practice of law, accounting, or certain other enumerated activities (Code §199A(d)(2)) are in an SSTB and the QBI deduction for this pass-through income phases out or is barred when taxable income exceeds applicable limits. In 2019, no QBI deduction can be claimed if taxable income exceeds $421,400 on a joint return, $210,700 for singles and heads of households, and $210,725 for married persons filing separately (Rev. Proc. 2018-57). With respect to the sideline activity, a QBI deduction for someone with taxable income over the initial threshold amount is limited (in 2019, $321,400 on joint returns, $160,700 for singles and heads of households, and $160,725 for married persons filing separately), is based in part on W-2 wages (of which there may be none in a sideline activity) and the unadjusted basis of property immediately after acquisition (UBIA). Final regulations clarify the computation of the QBI deduction (T.D. 9847, Feb. 8, 2019).

Unprofitable Sideline Activities

Unfortunately, a sideline activity may not be profitable. When this happens, the IRS may challenge whether a taxpayer has a profit motive in conducting the activity. If a taxpayer lacks of a profit motive, then the hobby loss rules apply (Code §183). This means that all income from the activity is taxable, while no deductions are allowed in 2018 through 2025 (the period in which the write-off for miscellaneous itemized deductions subject to the 2% of adjusted gross income floor is suspended). These deductions cannot be carried forward; they are lost forever.

There are nine factors used by the IRS and courts to assess whether an activity is a hobby or a business (Code §1.183-2(b)):

(1) The manner in which the taxpayer carries on the activity

(2) The expertise of the taxpayer and his/her advisors

(3) The time and effort expended by the taxpayer in carrying on the activity

(4) The expectation that assets used in the activity may appreciate in value

(5) The success of the taxpayer in carrying on other similar or dissimilar activities

(6) The taxpayer's history of income or losses with respect to the activity

(7) The amount of occasional profit, if any, which is earned

(8) The financial status of the taxpayer

(9) The elements of personal pleasure or recreation

The IRS has an Audit Technique Guide (ATG) explaining these nine factors in greater detail and advising agents what to look for in making a hobby determination. No single factor is controlling.

Recent Examples of Hobby Activities

The issue of hobby losses gives rise to considerable litigation. Here are examples of two recent cases on point.

Plane restoration. A former naval officer and commercial airline pilot restored a Fairey Firefly, a British plane used during World War II and through the 1960s. He spent considerable money doing this and expected to earn a return through air shows and leasing activities (potentially with the U.S. government). But he never actually earned much. The Tax Court held that this was a hobby activity (Kurdziel, Jr., TC Memo 2019-20). He didn't run this activity like a business; there was no business plan or separate books and records. He used the plane to promote another one of his businesses (a flight training school), but profits from the Fairey Firefly were merely hopes and dreams.

Yacht charter operations. A couple (the husband was a highly successful CPA) bought a $4.6 million yacht and spent another $10 million refitting it for a round-the-world trip. But health issues and financial concerns ended thoughts of a trip. Instead, the couple wanted to use the yacht for charter through two charter brokerage companies. There was considerable advertising, but only one charter of $150,000. All the while, the couple used the boat for diving and other personal activities. The Tax Court held that this was a hobby activity (Steiner, TC Memo 2019-25). While there was a business bank account, the couple paid most of the expenses (e.g., a full-time crew) from their personal bank accounts or with their personal credit cards. This was an activity for their personal pleasure and recreation and not primarily to make a profit.

Conclusion

When a sideline activity is profitable, consider its impact on the QBI deduction. When it comes to a sideline activity viewed as a hobby, there is no tax advantage. Thus, anyone engaged in a sideline activity should be sure to review the nine factors and conduct the activity in such a way as to demonstrate a profit motive. That way, if there are losses, they may still be deductible.

Sidney Kess, CPA-attorney, is of counsel at Kostelanetz & Fink and senior consultant to Citrin Cooperman & Company.