Are you engaged in a trade or business and subject to self-employment taxes, or are you participating in a hobby and subject to net investment income tax? Often, STA’s clients must confront this tax version of Sophie’s Choice. Even the co-producer of the Grammy-winning song “Midnight Train to Georgia,” had to provide substantial evidence, from various sources of income, and demonstrate how he ran his company in a “business-like manner” and eligible to claim deductions as a trade or business.[1] Under the same standard, the relevant facts and circumstances disproved an author’s assertion that certain income derived from her hobby. Both cases illustrate how the IRS will stack the odds against you unless you keep meticulous business records, and seek proper tax advice.
Under §162 and §212 of the Internal Revenue Code (“IRC”), you may deduct ordinary and necessary expenses generated by your trade or business. Generally, you may deduct the costs from activities engaged in for profit, but may not deduct expenses for dealings primarily engaged in as a hobby, or for recreation. As such, the IRC defines hobbies as activities not pursued for profit. Section 1.183-2 of the Income Tax Regulations includes a nine-factor list to determine whether your undertakings are engaged in for profit. As discussed in another article, “Deduct What You Love, With Hobby Losses,” if you have a reasonable expectation of profit and demonstrate a profit-seeking motive, then the IRS generally maintains that you are pursuing a vocation and allows you to deduct the associated expenses. Otherwise, you have a hobby, and may only deduct costs to the extent of your hobby-income.
Depending on how you file your taxes, you may owe self-employment or payroll taxes on the income you receive from your trade or business. Alternatively, you might owe net investment income tax on income from your hobbies. Specifically, royalty income not earned in the course of the taxpayer’s trade or business is not subject to self-employment tax, but is subject to the Net Investment Income Tax reported on Schedule E (Form 1040) as “supplemental income,” and is taxed as ordinary income. What happens when someone tries to bifurcate their income between investment income subject to net investment income tax, and trade or business income subject to self-employment tax?
In Barker v. Commr. of Internal Revenue, Cecile Barker kept financial records of SoBe’s ventures and his full-time involvement with the company. However, he needed to prove that the business expenses were ordinary and necessary costs incurred from the company’s operations to be entitled to the deductions he claimed. The business was an entertainment company that built artists’ brands. The company entered into contracts with influencers, writers, and the Isolation Network to produce, promote, and distribute music for its signed artists.
To claim deductions as business expenses under IRC §162, you must be engaged in a business for profit. Whether you can demonstrate the requisite profit-seeking motive to the IRS does not depend on your business making an actual monetary profit. SoBe was not profitable from 2002 through 2011. The IRS argued that the company was Mr. Barker’s hobby, and thus could not deduct its business expenses or losses. He responded by proving that he worked full-time to build SoBe’s brand. At litigation, Mr. Barker produced;
- SoBe’s general ledger,
- The company’s internally prepared journals,
- Bank account statements from 2002 through 2012, and
- Copies of SoBe’s checks from 2006 to 2010 to the Tax Court.
The Tax Court ruled that SoBe was a business, but Mr. Barker’s battle was not over.
Mr. Barker had to convince the Tax Court that his business incurred expenses and Net Operating Losses (“NOL”) from its operations. Unfortunately, he paid for various expenses recorded in SoBe’s general ledger by credit card or cash. At litigation, Mr. Barker produced SoBe’s bank statements to the Tax Court. However, the bank statements:
- Failed to differentiate between the amounts paid by credit cards or cash; and
- Did not describe the business purpose of the expenses.
Furthermore, Mr. Barker did not produce copies of;
- SoBe’s checks from 2003, 2004, 2005, or 2011, and
- He did not include SoBe’s general ledger for tax years 2003, 2004, 2010, and 2011.
Thus, In Barker v. Commr. of Internal Revenue, the Tax Court held that SoBe was a trade or business and eligible to claim deductions for business expenses under §162. However, Mr. Barker failed to provide convincing evidence that specific amounts paid by the company were legitimate business expenses. Therefore, the Tax Court ruled that Mr. Barker’ could not claim SoBe’s losses and expenses against his other income.
Whether you have a business or a hobby, the IRS will argue for whichever result benefits them the most! For Mr. Barker, that meant disallowing losses. But in the next case, for Karen Slaughter, it meant self-employment.
In Slaughter v. Commr. of Internal Revenue, the Tax Court held that author Karin Slaughter’s royalty income was subject to self-employment taxes.[2] Karin Slaughter’s income derived from her trade and business would be subject to self-employment tax. However, because she relied on expert tax preparers, Karin Slaughter was not held liable for a negligence penalty on her 2010 and 2011 tax deficiencies in self-employment taxes.
Under her contracts, Karin Slaughter received three types of payments; a non-refundable advance, royalties based on a percentage of revenue produced from the sale of her books, and a bonus for sublicensing audio or movie versions of her books. Karin Slaughter also licensed her name and likeness to her publishers, signed non-compete clauses, and agreed to attend promotional events to build her brand. She argued that as an author, her royalty income should be excluded from her business income because her business income included solely what she made from writing. Specifically, she argued that her royalty income resulted from her brand, but that the royalty income from her brand was distinct from her business income from her writing; and therefore, not subject to self-employment tax. An interesting thought exercise for sure, but it did not convince the tax court.
In response, the IRS argued that Karin Slaughter’s royalties were not separate and distinct from her income as an author; therefore, the royalties and writing income all derived from selling her manuscripts. Additionally, the IRS argued that Karin Slaughter’s shopping around for publishers, agents, and media influencers to expand her brand demonstrated her profit-seeking motive. As such, the IRS successfully argued that her writing and royalties both stemmed from her profession of being an author. Accordingly, the Tax Court determined that author Karin Slaughter’s branding contributed to her success as an author. Therefore, any income or fees she reaped from her writing or her renown as a writer were subject to self-employment tax.
While the financial records Cecile Barker produced convinced the tax court that he was engaged in a business for profit, he was not detailed enough in his recordkeeping to utilize SoBe’s business expenses or NOL deductions to offset his income. If, as a successfully self-employed individual in your trade or business, you generate profits, royalties, or licensing fees from your work, then you will likely owe self-employment tax on any income generated by your work. Like Karin Slaughter, you probably cannot avoid paying self-employment tax by simply partitioning your income between your career and your branding. Either way, you will lose unless you keep meticulous business records! Use STA’s tax experts to control your tax story and protect yourself and your brand.
[1] Barker v. Commr. of Internal Revenue, 115 T.C.M. (CCH) 1352 (Tax 2018).
[2] Slaughter v. Commr. of Internal Revenue, T.C.M. (RIA) 2019-065 (Tax 2019).
