Business Structure for revenue generating hobbies

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Kimota
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Business Structure for revenue generating hobbies

Post by Kimota »

DW and I have some hobbies that are revenue generating... we're both severely in the red, but this year we grossed $50K with our projects. I feel like we've crossed the threshold and need to capture these activities in some kind of business structure... and wanted to see if anyone had any good recommendations that details the pros and cons for LLC vs S-Corp vs etc.

Thanks!
MrJedi
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Re: Business Structure for revenue generating hobbies

Post by MrJedi »

Do you ever intend on producing a profit? Hobbies are miscellaneous itemized deductions which were recently eliminated from deductibility.
alex_686
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Re: Business Structure for revenue generating hobbies

Post by alex_686 »

MrJedi wrote: Wed Sep 23, 2020 6:10 pm Do you ever intend on producing a profit? Hobbies are miscellaneous itemized deductions which were recently eliminated from deductibility.
I would not call their deletion 'recent'. Not sure exactly what you are referencing but there have been rules for 50+
years.

The grist is that you had better be trying to run a for-profit business. The classic example was turning your pet dog into a show and breeding dog. For a while it was llamas.

Going into red for start up is fine. Failing is fine. There are (or at least was) some wiggle room in the interpretations. But you have to make some reasonable presentation that you are running a for profit business.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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MP123
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Re: Business Structure for revenue generating hobbies

Post by MP123 »

Are you currently reporting these activities as a sole proprietor on schedule C?

That might be all you need to do. LLCs are state registered entities. S-Corps are corporations that have elected to be taxed as pass through income. Either might be appropriate depending on the nature of what you're doing, but might also just add additional complexity that you don't need.
BogleTaxPro
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Re: Business Structure for revenue generating hobbies

Post by BogleTaxPro »

MP123 wrote: Wed Sep 23, 2020 6:34 pm Are you currently reporting these activities as a sole proprietor on schedule C?

That might be all you need to do. LLCs are state registered entities. S-Corps are corporations that have elected to be taxed as pass through income. Either might be appropriate depending on the nature of what you're doing, but might also just add additional complexity that you don't need.
+1
AnEngineer
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Re: Business Structure for revenue generating hobbies

Post by AnEngineer »

alex_686 wrote: Wed Sep 23, 2020 6:16 pm
MrJedi wrote: Wed Sep 23, 2020 6:10 pm Do you ever intend on producing a profit? Hobbies are miscellaneous itemized deductions which were recently eliminated from deductibility.
I would not call their deletion 'recent'. Not sure exactly what you are referencing but there have been rules for 50+
years.

The grist is that you had better be trying to run a for-profit business. The classic example was turning your pet dog into a show and breeding dog. For a while it was llamas.

Going into red for start up is fine. Failing is fine. There are (or at least was) some wiggle room in the interpretations. But you have to make some reasonable presentation that you are running a for profit business.
The TCJA changed it so you can no longer deduct hobby expenses against hobby income. Before you could break even and pay no tax. Now you must pay tax on revenue, even if you make no profit.
fyre4ce
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Re: Business Structure for revenue generating hobbies

Post by fyre4ce »

First we have to distinguish between a hobby and a business. A business is something you intend to do regularly and for profit. You don't have to actually do it regularly, or earn a profit for it to be treated as a business for tax purposes. But, you are usually expected to earn a profit in at least two out of every five years (there may be exceptions for certain industries). You are allowed to report, and deduct, a business loss (both for startup costs and ongoing operations), but if you are reporting a loss year-after-year, the IRS will start to doubt whether you're actually trying to make money. Business profits and losses are reported on Schedule C for a sole proprietorship, and on a Form 1120S if you're incorporated as a S Corp.

Hobbies are activities that don't fit in the above definition. Like many parts of the tax code, there can be some grey areas. Like what about selling antiques? Some people enjoy traveling to antique shows and buying and selling antiques. Maybe they do it both for enjoyment and with the hope of earning a profit. You don't have to hate your job for it to count as a business, and in fact the government has an interest in incentivizing people to go into businesses that they enjoy doing. A good test would be- if you stopped making a profit at the activity, would you keep doing it for enjoyment? If so, it's probably a hobby and not a business. But like many grey areas in the tax code, I'm personally comfortable leaning a bit toward the direction that's favorable to me. Hobby income is reported on your personal return as "Other income" (Form 1040 Schedule 1 line 8).

Businesses have the advantage that costs can be deducted against profit, and as I mentioned you can even report several years of loss. Costs can include cell phone use, internet use, home office, driving (other than what counts as a commute) etc. Another advantage is that you can open up a Solo 401k and defer some of your income. On the negative side, you have to pay both halves of payroll tax (up to 16.3%). There may also be licensing requirements. For hobbies, you have to report profits, but can't deduct any losses. However, you don't have to pay any payroll tax, and you're less likely to need a license. No Solo 401k. There's no clear winner here; it depends on each taxpayer's individual situation.

Forming an LLC is probably not necessary, unless you think there's a decent chance you'll get sued. Forming an S-corp is probably a bad idea unless you have $100,000's of income. There are significant costs to form and maintain the corporation, and the tax benefits are small (just avoiding payroll tax on a percentage of your business income). The QBI deduction is often less from an S-corp than a sole proprietorship, so an S-corp could actually cost you taxes.
AnEngineer
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Re: Business Structure for revenue generating hobbies

Post by AnEngineer »

fyre4ce wrote: Thu Sep 24, 2020 9:23 am... For hobbies, you have to report profits...
After TCJA this is NOT true. Hobbies are taxed on revenue, not profit. If you spend $1000 to bring in $1100, you are taxed on $1100. If you spend $1000 to bring in $900, you are taxed on $900.

Only if you can satisfy the IRS that you are operating a business and not a hobby can you deduct costs from revenue.
fyre4ce
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Re: Business Structure for revenue generating hobbies

Post by fyre4ce »

AnEngineer wrote: Thu Sep 24, 2020 9:39 am
fyre4ce wrote: Thu Sep 24, 2020 9:23 am... For hobbies, you have to report profits...
After TCJA this is NOT true. Hobbies are taxed on revenue, not profit. If you spend $1000 to bring in $1100, you are taxed on $1100. If you spend $1000 to bring in $900, you are taxed on $900.

Only if you can satisfy the IRS that you are operating a business and not a hobby can you deduct costs from revenue.
I thought the "can't deduct costs" applies to things like deducting a home computer, phone, travel, etc. I assume you can at least deduct the cost of goods sold. You're telling me if I buy an antique for $1000 and sell it for $1100, I have to report $1100 taxable income without being able to deduct the $1000 anywhere? That doesn't seem right. But I have been wrong before, and if so I'll edit my post.
AnEngineer
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Re: Business Structure for revenue generating hobbies

Post by AnEngineer »

fyre4ce wrote: Thu Sep 24, 2020 9:45 am
AnEngineer wrote: Thu Sep 24, 2020 9:39 am
fyre4ce wrote: Thu Sep 24, 2020 9:23 am... For hobbies, you have to report profits...
After TCJA this is NOT true. Hobbies are taxed on revenue, not profit. If you spend $1000 to bring in $1100, you are taxed on $1100. If you spend $1000 to bring in $900, you are taxed on $900.

Only if you can satisfy the IRS that you are operating a business and not a hobby can you deduct costs from revenue.
I thought the "can't deduct costs" applies to things like deducting a home computer, phone, travel, etc. I assume you can at least deduct the cost of goods sold. You're telling me if I buy an antique for $1000 and sell it for $1100, I have to report $1100 taxable income without being able to deduct the $1000 anywhere? That doesn't seem right. But I have been wrong before, and if so I'll edit my post.
I don't know if there's an exception for something like antiques. You could argue that's collectible investing. I don't know what's the dividing line between that and buying a used car and letter selling it, for which you certainly don't owe income tax.

However, if you run an Etsy shop as a hobby (i.e. not to make money, but to recoup costs of your hobby), then you cannot deduct the cost of materials.
Example: Charles paints part-time as a hobby. He earns $3,000 from selling paintings in 2018 and has $2,000 in expenses. He must report and pay tax on his $3,000 in hobby income, but he may not deduct any of his hobby expenses, even if he itemizes his personal deductions.
-https://www.nolo.com/legal-encyclopedia ... hobby.html
fyre4ce
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Re: Business Structure for revenue generating hobbies

Post by fyre4ce »

AnEngineer wrote: Thu Sep 24, 2020 10:01 am
fyre4ce wrote: Thu Sep 24, 2020 9:45 am
AnEngineer wrote: Thu Sep 24, 2020 9:39 am
fyre4ce wrote: Thu Sep 24, 2020 9:23 am... For hobbies, you have to report profits...
After TCJA this is NOT true. Hobbies are taxed on revenue, not profit. If you spend $1000 to bring in $1100, you are taxed on $1100. If you spend $1000 to bring in $900, you are taxed on $900.

Only if you can satisfy the IRS that you are operating a business and not a hobby can you deduct costs from revenue.
I thought the "can't deduct costs" applies to things like deducting a home computer, phone, travel, etc. I assume you can at least deduct the cost of goods sold. You're telling me if I buy an antique for $1000 and sell it for $1100, I have to report $1100 taxable income without being able to deduct the $1000 anywhere? That doesn't seem right. But I have been wrong before, and if so I'll edit my post.
I don't know if there's an exception for something like antiques. You could argue that's collectible investing. I don't know what's the dividing line between that and buying a used car and letter selling it, for which you certainly don't owe income tax.

However, if you run an Etsy shop as a hobby (i.e. not to make money, but to recoup costs of your hobby), then you cannot deduct the cost of materials.
Example: Charles paints part-time as a hobby. He earns $3,000 from selling paintings in 2018 and has $2,000 in expenses. He must report and pay tax on his $3,000 in hobby income, but he may not deduct any of his hobby expenses, even if he itemizes his personal deductions.
-https://www.nolo.com/legal-encyclopedia ... hobby.html
I think if you flip a car and earn profit, you have to report it as taxable income, either as a capital gain or Other income. Even if you didn't intend to make a profit.

Clearly there's some grey area between investment, hobby, and business. Even for a legit hobby, I'd be very surprised if you couldn't deduct the cost of goods sold. But even then there's some grey area - what about building a classic car? Seems like you should at least be able to deduct the cost of the engine, wheels, etc that go into it.

In any case, I'm not a tax pro of any sort, so don't take my opinion as gospel. Sounds like with $50k of income, OP should consult a "real" CPA.
AnEngineer
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Re: Business Structure for revenue generating hobbies

Post by AnEngineer »

fyre4ce wrote: Thu Sep 24, 2020 10:19 am ... Even for a legit hobby, I'd be very surprised if you couldn't deduct the cost of goods sold. ...
Well, be surprised, because that's the current law.
...Sounds like with $50k of income, OP should consult a "real" CPA.
Agreed.
fyre4ce
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Re: Business Structure for revenue generating hobbies

Post by fyre4ce »

AnEngineer wrote: Thu Sep 24, 2020 10:24 am
fyre4ce wrote: Thu Sep 24, 2020 10:19 am ... Even for a legit hobby, I'd be very surprised if you couldn't deduct the cost of goods sold. ...
Well, be surprised, because that's the current law.
I looked it up, and I don't think you're correct. Quoted from IRS Pub 535 (2019) (post-TCJA) in "Not for profit activities":

Gross Income

Gross income from a not-for-profit activity includes the total of all gains from the sale, exchange, or other disposition of property, and all other gross receipts derived from the activity. Gross income from the activity also includes capital gains and rents received for the use of property that is held in connection with the activity.

You can determine gross income from any not-for-profit activity by subtracting the cost of goods sold from your gross receipts. However, if you determine gross income by subtracting cost of goods sold from gross receipts, you must do so consistently, and in a manner that follows generally accepted methods of accounting.


So, the IRS explicitly allows deduction of cost of goods sold. I would argue the bolded portion also includes cost of parts, and cost of any work done on those parts. So, if you buy a classic car chassis for $10k, an engine for $5k, send the engine out to be rebuilt for $2k, build the car up and sell it for $20k, you would report a gross income of $3k.
Last edited by fyre4ce on Thu Sep 24, 2020 11:30 am, edited 1 time in total.
AnEngineer
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Re: Business Structure for revenue generating hobbies

Post by AnEngineer »

Hrmmm, perhaps all the reporting I've read has been a bit exaggerated. I guess it depends on what counts as "cost of goods sold". In the painter, you could presumably deduct the cost of canvas, framing, and paint that ends up in the painting (that you sell), but not other paint or brushes, or other supplies, or any money you spend on the painting space. If costs are more on tools and equipment though, you're still out of luck (for the next few years).
fyre4ce
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Re: Business Structure for revenue generating hobbies

Post by fyre4ce »

AnEngineer wrote: Thu Sep 24, 2020 11:22 am Hrmmm, perhaps all the reporting I've read has been a bit exaggerated. I guess it depends on what counts as "cost of goods sold". In the painter, you could presumably deduct the cost of canvas, framing, and paint that ends up in the painting (that you sell), but not other paint or brushes, or other supplies, or any money you spend on the painting space. If costs are more on tools and equipment though, you're still out of luck (for the next few years).
This would be my interpretation of the current law. Again, I'm not a tax pro, just some person on the internet.
Chip
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Re: Business Structure for revenue generating hobbies

Post by Chip »

fyre4ce wrote: Thu Sep 24, 2020 11:06 am You can determine gross income from any not-for-profit activity by subtracting the cost of goods sold from your gross receipts. However, if you determine gross income by subtracting cost of goods sold from gross receipts, you must do so consistently, and in a manner that follows generally accepted methods of accounting.[/i]

So, the IRS explicitly allows deduction of cost of goods sold. I would argue the bolded portion also includes cost of parts, and cost of any work done on those parts. So, if you buy a classic car chassis for $10k, an engine for $5k, send the engine out to be rebuilt for $2k, build the car up and sell it for $20k, you would report a gross income of $3k.
Unfortunately many of the IRS pubs haven't been successfully revised to take TCJA into account.

I believe that the section you quoted is primarily used to determine, via gross income over multiple years, whether an activity is for profit or not. Therefore I believe it does not "explicitly allow a deduction for COGS" for hobbies.

Here's a quote from Pub 17 that I believe is more on point:
IRS Pub 17 wrote:Hobby Expenses
A hobby isn't a business because it isn't carried on to make a profit. Hobby expenses are miscellaneous itemized deductions and can no longer be deducted. See Not-for-Profit Activities in chapter 1 of Pub. 535.
fyre4ce
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Re: Business Structure for revenue generating hobbies

Post by fyre4ce »

Chip wrote: Thu Sep 24, 2020 2:08 pm
fyre4ce wrote: Thu Sep 24, 2020 11:06 am You can determine gross income from any not-for-profit activity by subtracting the cost of goods sold from your gross receipts. However, if you determine gross income by subtracting cost of goods sold from gross receipts, you must do so consistently, and in a manner that follows generally accepted methods of accounting.[/i]

So, the IRS explicitly allows deduction of cost of goods sold. I would argue the bolded portion also includes cost of parts, and cost of any work done on those parts. So, if you buy a classic car chassis for $10k, an engine for $5k, send the engine out to be rebuilt for $2k, build the car up and sell it for $20k, you would report a gross income of $3k.
Unfortunately many of the IRS pubs haven't been successfully revised to take TCJA into account.

I believe that the section you quoted is primarily used to determine, via gross income over multiple years, whether an activity is for profit or not. Therefore I believe it does not "explicitly allow a deduction for COGS" for hobbies.

Here's a quote from Pub 17 that I believe is more on point:
IRS Pub 17 wrote:Hobby Expenses
A hobby isn't a business because it isn't carried on to make a profit. Hobby expenses are miscellaneous itemized deductions and can no longer be deducted. See Not-for-Profit Activities in chapter 1 of Pub. 535.
I see what you're saying but that's not how I read it. First, Pub 535 (2019) has been updated, at least in part, to reflect TCJA. Look at the note immediately following the passage I quoted: "Limit on Deductions - You can no longer claim any miscella-neous itemized deductions. Miscella-neous itemized deductions are those deductions that would have been subject to the 2%-of-adjusted-gross-income limitation. You can still claim certain expenses as itemized de-ductions on Schedule A (Form 1040 or 1040-SR). That doesn't necessarily mean the other parts must be 100% accurate, but it would be a huge oversight to update the Pub and forget to edit the explicit language I quoted.

Also, I don't take that section to be merely defining what is a not-for-profit activity. The text between the section header "Not For Profit Activities" and the "Gross Income" header seems to serve that purpose. Under "Gross Income", a not for profit activity is already presumed. That one sentence seems crystal-clear: "You can determine gross income from any not-for-profit activity by subtracting the cost of goods sold from your gross receipts."

I dunno, maybe a tax expert will correct me. It's just extremely hard for me to imagine the IRS trying to nail someone who bought an antique for $50k, sold it for $52k, and reported $2k of Other income, for $50k of underreported income.
neverpanic
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Re: Business Structure for revenue generating hobbies

Post by neverpanic »

fyre4ce wrote: Thu Sep 24, 2020 2:28 pm
Chip wrote: Thu Sep 24, 2020 2:08 pm
fyre4ce wrote: Thu Sep 24, 2020 11:06 am You can determine gross income from any not-for-profit activity by subtracting the cost of goods sold from your gross receipts. However, if you determine gross income by subtracting cost of goods sold from gross receipts, you must do so consistently, and in a manner that follows generally accepted methods of accounting.[/i]

So, the IRS explicitly allows deduction of cost of goods sold. I would argue the bolded portion also includes cost of parts, and cost of any work done on those parts. So, if you buy a classic car chassis for $10k, an engine for $5k, send the engine out to be rebuilt for $2k, build the car up and sell it for $20k, you would report a gross income of $3k.
Unfortunately many of the IRS pubs haven't been successfully revised to take TCJA into account.

I believe that the section you quoted is primarily used to determine, via gross income over multiple years, whether an activity is for profit or not. Therefore I believe it does not "explicitly allow a deduction for COGS" for hobbies.

Here's a quote from Pub 17 that I believe is more on point:
IRS Pub 17 wrote:Hobby Expenses
A hobby isn't a business because it isn't carried on to make a profit. Hobby expenses are miscellaneous itemized deductions and can no longer be deducted. See Not-for-Profit Activities in chapter 1 of Pub. 535.
I see what you're saying but that's not how I read it. First, Pub 535 (2019) has been updated, at least in part, to reflect TCJA. Look at the note immediately following the passage I quoted: "Limit on Deductions - You can no longer claim any miscella-neous itemized deductions. Miscella-neous itemized deductions are those deductions that would have been subject to the 2%-of-adjusted-gross-income limitation. You can still claim certain expenses as itemized de-ductions on Schedule A (Form 1040 or 1040-SR). That doesn't necessarily mean the other parts must be 100% accurate, but it would be a huge oversight to update the Pub and forget to edit the explicit language I quoted.

Also, I don't take that section to be merely defining what is a not-for-profit activity. The text between the section header "Not For Profit Activities" and the "Gross Income" header seems to serve that purpose. Under "Gross Income", a not for profit activity is already presumed. That one sentence seems crystal-clear: "You can determine gross income from any not-for-profit activity by subtracting the cost of goods sold from your gross receipts."

I dunno, maybe a tax expert will correct me. It's just extremely hard for me to imagine the IRS trying to nail someone who bought an antique for $50k, sold it for $52k, and reported $2k of Other income, for $50k of underreported income.
I'm not a tax expert, but you are correct. The $50K had already been taxed - that's not new income.

In a very general sense, the IRS doesn't want people pretending that their hobbies are businesses in order to take advantage of deductions (for regular expenses) that a real business would be eligible to take. If it were allowed, then the public would essentially be subsidizing one's hobbies.

Yes, the LLC provides asset protection, but forming an LLC or even just registering a DBA also demonstrates intent to earn a profit as an actual business in a way that operating as an unregistered sole proprietorship does not.
I am not a financial professional or guru. I'm a schmuck who got lucky 10 times. Such is the life of the trader.
alex_686
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Re: Business Structure for revenue generating hobbies

Post by alex_686 »

neverpanic wrote: Thu Sep 24, 2020 3:01 pm In a very general sense, the IRS doesn't want people pretending that their hobbies are businesses in order to take advantage of deductions (for regular expenses) that a real business would be eligible to take. If it were allowed, then the public would essentially be subsidizing one's hobbies.
I think you are are debating over a deliberately grey area of the tax code. The IRS is not going to give a hard and fast rule here. That would invite gameinship of the taxcode.

I suspect that if the OP has 50k in revenue that they have graduated from hobby to small business.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
MBB_Boy
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Re: Business Structure for revenue generating hobbies

Post by MBB_Boy »

AnEngineer wrote: Thu Sep 24, 2020 11:22 am Hrmmm, perhaps all the reporting I've read has been a bit exaggerated. I guess it depends on what counts as "cost of goods sold". In the painter, you could presumably deduct the cost of canvas, framing, and paint that ends up in the painting (that you sell), but not other paint or brushes, or other supplies, or any money you spend on the painting space. If costs are more on tools and equipment though, you're still out of luck (for the next few years).
Wouldn't be the first time reporting is exaggerated. Going in assumption at this point :sharebeer
Topic Author
Kimota
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Re: Business Structure for revenue generating hobbies

Post by Kimota »

Thanks all for this. Definitely consulting a CPA on a way forward.
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