Arts and Crafts Hobby Loss Rules

I find there is confusion on the part of some of my arts and crafts clients about the tax deductibility of their expenses, including office in the home. Some crafters have been told by their peers to start a business and write off everything but the kitchen sink as a business expense. It's important to understand if your arts and crafts efforts qualify as a business for tax purposes or if you're a hobby.

So wondering how to report your income and expenses? Here's a simple explanation on how to handle your arts and crafts revenue and expense.

What's the Big Deal About Being Classified an Arts and Crafts Hobby or Business?

You may be wondering why it matters if you operate a hobby or a business as long as you record all your income and only legitimate expenses on your tax return. Well, the big deal is how your arts and crafts expenses are handled if you lose money selling your crafts year after year. This is covered in Internal Revenue Code 183 (aka Hobby Loss Rules)

If you operate as a sole proprietor, partnership, or S-Corporation to be able to potentially write off all your arts and crafts expenses, your work has to be regarded as a business rather than a hobby. The IRS has strict criteria as to the definition of a hobby versus a business. Straight-up corporations are not subject to the IRS's hobby loss rules.

Arts and Crafts Business Intent

Your arts and crafts business meets the business versus hobby criteria if you have a profit three years out of the last five tax years. Here are some additional items to consider when deciding if you can be taxed a hobby or a business:

*Are you planning to live on the net profit from the business?

*Have you made a profit in a similar business in the past?

*If there are losses, is it because you are in the start-up phase of the business, or perhaps due to circumstances beyond your control, such as being located in a weather-related disaster area.

*Are you changing the way you operate your crafts business to move into a profit position?

Using Arts and Crafts Losses to Offset Other Income

Wondering why the IRS cares if your small business makes money? Well, it goes beyond the business tax-collecting standpoint. If you're operating as one of the business entities I mentioned previously, any arts and crafts business loss serves to offset other items of income you show on your Form 1040.

For example, if you or your spouse also has W-2 wages or other income, a loss for the arts and crafts business will reduce your amount of taxable income. Unfortunately, this has been an area of abuse in the past as people set up sham businesses to take a loss.

Treatment of Hobby Arts and Crafts Expenses

I knew a woman who operated as a sole proprietorship selling jewelry. Well, you guessed it; her only client was herself. It's a nice gig to try to write off personal living expenses as business losses, but it's against tax code.

So what happens if the IRS audits your tax return and sees that you have losses more than three of five years, considers the other bulleted criteria, and reclassifies your business losses as hobby losses? Well, it's not good. All of your gross income is taxed, while your expenses in the production of that revenue are greatly reduced.

Bottom Line - What This Means for Your Arts and Crafts Business

As long as your arts and crafts business consistently has net income, you don't have to worry about the distinction between being a business or hobby when writing off your expenses directly against your income. Additionally, if you haven't started making a profit in the first two years of running your arts and crafts business, you need to go back to the drawing board and figure out why. It shouldn't take the risk of an IRS audit for you to realize that something about the way you are doing business is not working.

My first article about hobby losses discusses how and why your sole proprietorship, partnership or S-corporation may be reclassified as a hobby for tax return purposes. This is a totally different from making crafts as a hobby. A hobbyist doesn't intend to operate a business; this is something you do just for fun and maybe to give as gifts or use yourself. Nothing wrong with that. Additionally, most arts and crafts businesses have their origin in a hobby the eventual business owner enjoyed.

However, what if you operate an arts and crafts business as a sole proprietorship or flow through and your business loses money year after year. Well, if your tax return is selected for audit by the Internal Revenue Service (IRS) and they find you don't have a serious business intent, the way you report your craft sales and expenses on your tax return changes and it usually will increase the amount of income tax you'll have to pay.

Reporting Arts and Crafts Hobby Income

Gross receipts from your hobby sales are reported on page 1 of Form 1040 as other income on line 21. This adds to your adjusted gross income. However, it's usually not subject to self-employment tax - only income tax - if your hobby making activity is not continuous or regular or meant to turn a profit (even if you do so occasionally). Ok, simple enough you may be saying - what's the catch?

Reporting Arts and Crafts Hobby Expenses

Well, the catch comes in because you must itemize hobby expenses on Schedule A. If you don't have enough other deductions to itemize, you've lost the entire expense deduction. You are also not allowed to deduct hobby expenses on the Schedule A in excess of your gross arts and crafts hobby income. And, hobby expenses are among the deductions subject to the 2% of the adjusted gross income floor.

So, let's say you make jewelry and your customers pay you $1,000. Your raw materials to make the jewelry and your jewelry-making office expenses such as packing material, printer paper and toner total $1,200. Your first limitation when deducting your expenses is your jewelry sales income limit of $1,000. Your second limitation comes into play with your adjusted gross income. If your adjusted gross income is $40,000, 2% of that is $800. You can only deduct $200 in expenses ($1,000 - $800 = $200).

As you can see, expenses that originally total $1,200 are only reducing your taxable income by $200. For more information about deducting hobby expenses, check out IRS Publication 535.