Whether a revenue-generating activity constitutes a trade or business is usually straightforward — until it isn't. The most common confusion on this issue occurs around hobbies that generate revenue and investments that contain a degree of personal involvement. Many of these are difficult to distinguish from trades or businesses. For these activities, having the status of a trade or business can allow certain tax deductions, dictate filing methods and responsibilities, and impose additional taxes.
Historically, this has been most relevant to allowing deductions, imposing self-employment tax, using Sec. 179 expensing, and complying with filing and information-reporting requirements. Since the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, was enacted, it has also become relevant to allowing the Sec. 199A deduction for qualified business income (QBI). All these areas specifically refer to an activity's status as a trade or business, making this determination critical.
The first step in determining whether an activity is a trade or business is understanding the definition. While numerous provisions refer to an activity's status as a trade or business, nowhere in the Code or regulations is it defined. As such, this definition has been left to the courts to determine over the years. The standard for differentiating a trade or business comes from Groetzinger, 480 U.S. 23 (1987).
In response to whether a professional gambler's expenses constituted a legitimate business deduction, the Supreme Court concluded: "[T]o be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and … the taxpayer's primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify." While Groetzinger primarily dealt with the status of a taxpayer's activity as a trade or business versus a hobby, the same standard has been used in numerous court cases to differentiate between a trade or business versus an investment (e.g., Yaryan, T.C. Memo. 2018-129).
Allowance of deductions
One of the greatest concerns surrounding whether an activity constitutes a trade or business is the allowance of deductions. Sec. 162(a) provides: "There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." If an activity does not constitute a trade or business, Sec. 162 does not apply, and no deductions may be taken directly against income arising from that activity.
If an activity fails to qualify as a trade or business under Sec. 162 because it is not engaged in for profit, it is often considered a hobby, and Sec. 183 applies (barring status as a not-for-profit organization, which is beyond the scope of this discussion). Sec. 183(d) provides a presumption that, generally, any activity with greater revenue than deductions in at least three out of the five consecutive years ending with the tax year is engaged in for profit, but the IRS often employs a corollary, more than three out of five years as loss, when challenging the profit motive of an activity. Once challenged, the final determination of a profit motive looks to the nine nonexclusive relevant factors indicated in Regs. Sec. 1.183-2(b):
- The manner in which the taxpayer carries on the activity;
- The expertise of the taxpayer or their advisers;
- The time and effort expended by the taxpayer in carrying on the activity;
- The expectation that assets used in the activity may appreciate in value;
- The success of the taxpayer in carrying on other similar or dissimilar activities;
- The taxpayer's history of income or losses with respect to the activity;
- The amount of occasional profits, if any, that are earned;
- The taxpayer's financial status; and
- Elements of personal pleasure or recreation.
If no profit motive is deemed present, not only does the activity fail to qualify as a trade or business, but the more onerous deduction rules of Sec. 183 apply. These limit deductions to gross income from the activity, and the deductions must be included among miscellaneous deductions under Sec. 67(b), which the TCJA suspended for tax years 2018 through 2025 and in other years are allowed only to the extent they exceed 2% of adjusted gross income.
The QBI deduction and Sec. 179 expensing
Other important deductions tied to trade or business status are Sec. 179 expensing and the QBI deduction under Sec. 199A. Sec. 179(b)(3)(A) states: "The amount allowed as a deduction … shall not exceed the aggregate amount of taxable income of the taxpayer … derived from the active conduct by the taxpayer of any trade or business." As such, any activity that fails to qualify as a trade or business cannot elect to expense a capital asset under Sec. 179.
Likewise, the Sec. 199A deduction, as stated in Sec. 199A(b)(1)(A), is based on "the sum of the amounts determined under paragraph (2) for each qualified trade or business carried on by the taxpayer." Not only must the activity be of a qualifying type for Sec. 199A, but it must also qualify as a trade or business to contribute to this deduction.
Not everything resulting from an activity's failing to meet the definition of trade or business is to a taxpayer's detriment. Most importantly, if an activity fails to meet the definition of a trade or business, it does not constitute self-employment, and self-employment tax does not apply to income from it. Sec. 1402(a) defines net earnings from self-employment as "the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member." Thus, self-employment tax does not apply unless the activity is a trade or business.
To avoid self-employment tax, it might be beneficial for a taxpayer to take a position there is a lack of profit motive for activities with minimal, if any, expenses and that are not concerned with the limitations of Sec. 183, or the applicability of Sec. 162 and/or Sec. 199A. For example, a retiree and avid outdoorsman who occasionally guides anglers might be able to take the position that the activity is a hobby. The same might be true for a carpenter who occasionally acts in theater or an accountant who sometimes writes science fiction. Under this position, if there are no, or minimal, expenses coupled with income, the net tax liability may be lower if self-employment tax did not apply.
Likewise, a nonrecurring or minimal-involvement activity could also be argued to not constitute a trade or business but to be carried on for the production of income under Sec. 212 and be exempt from self-employment tax. These activities are often considered investments and are not subject to the restrictions of Sec. 183, as they have a profit motive. However, these activities must deduct expenses under Sec. 212, which, like those under Sec. 183, are Sec. 67(b) miscellaneous itemized deductions and likewise suspended for 2018 through 2025.
In addition, if the taxpayer's participation in the activity is minimal, the material-participation requirements under Sec. 469 could classify the activity as passive, which, among other potential disadvantages, could subject the taxpayer to the net investment income tax under Sec. 1411. However, if a taxpayer is under the Social Security wage base, has unused passive losses, or is under the adjusted income threshold for Sec. 1411, taking the position the activity is not a trade or business but constitutes an investment activity might still be beneficial.
Filing and information-reporting requirements
Filing requirements are another area where constituting a trade or business creates different results. Per the instructions of Form 1065, U.S. Return of Partnership Income: "A partnership is the relationship between two or more persons who join to carry on a trade or business, with each person contributing money, property, labor, or skill and each expecting to share in the profits and losses of the business whether or not a formal partnership agreement is made." This is mirrored by IRS Publication 541, Partnerships:
An unincorporated organization with two or more members is generally classified as a partnership for federal tax purposes if its members carry on a trade, business, financial operation, or venture and divide its profits. However, a joint undertaking merely to share expenses is not a partnership. For example, co-ownership of property maintained and rented or leased is not a partnership unless the co-owners provide services to the tenants.
Thus, joint ventures that fail to qualify as a trade or business may not be required to file Form 1065. In these circumstances each member of the joint venture would report their share of income and expenses as either an investment or hobby activity on their income tax return.
Similarly, Regs. Sec. 1.6041-1 provides that "every person engaged in a trade or business shall make an information return for each calendar year with respect to payments it makes during the calendar year." This is paralleled in the instructions for Form 1099-MISC, Miscellaneous Income, ("Report on Form 1099-MISC only when payments are made in the course of your trade or business") and Form 1099-NEC, Nonemployee Compensation (like wording). While this does include a clarification that not-for-profits are considered a business for this purpose, there is no similar language pulling into the 1099 filing regime activities that have been deemed hobbies or investments.
When a revenue-generating activity fails to constitute a trade or business, it can have significant tax and filing ramifications. This situation can be due to either a lack of profit motive and/or a lack of continuity and regularity, resulting in treatment as a hobby or an investment, respectively. It can affect the ability to deduct expenses, the applicability of self-employment tax, the availability of the QBI deduction, and Sec. 179 expensing. It can also change an activity's filing and information-reporting requirements.
While these usually result in less favorable results to taxpayers, circumstances can arise where failing to constitute a trade or business can be beneficial. All the tax, administrative, and qualifying aspects of a situation should be considered if there is a possibility a revenue-generating activity may fail to constitute a trade or business and be considered a hobby or investment.
— Damien Falato, CPA, CGMA, MST, is a partner with Paresky Flitt & Co. LLP in Wayland, Mass. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.