I remember this exact issue coming up in a class I had in college. It was an independent study with a few of us that focused on the business of theatre, specifically geared towards freelancers. We learned all sorts of tidbits that most don't even consider until they're faced with it in the real world, and a lot regarding tax. I had forgotten the hobby rule until this thread came up, but it now rings clear again. If you're self employed you need to show a profit on your taxes in 3 out of 5 consecutive years to avoid following into the "hobby" category.
note: this is for federal returns only. I'm not familiar with MN tax law and frankly don't want to be, though from the admittedly miniscule amount of research I conducted it seems MN concurs with the IRS definition. If I am wrong, please correct me.For those not familiar, the way you'd show a loss is to claim deductions to the point where your AGI is down to $0, or in the red. What you generally should avoid is claiming deductions that take your AGI into the red for more than 2/5 years, else you may come up on the IRS's (or in this case, MN's) radar. Even if you show a profit of $1, in theory you should be OK.
Here is a snippet of an article on the Hobby Loss Rule, with the full article found
here.
Hobby Loss Rule of Thumb.
If a business reports a net profit in at least 3 out of 5 years, it is presumed to be a for-profit business. If a business reports a net loss in more than 2 out of 5 years, it is presumed to be a not-for-profit hobby.
This rule of thumb makes places a huge burden of proof on young businesses. On the one hand, the IRS expects new businesses to incur a loss. It is normal for a business to have a year or two of losses before becoming profitable. On the other hand, it is likely that a business could have several years of losses before ever making a profit. In fact, several such cases have been sent to the Tax Court.
If you cannot meet the 3-out-of-5 year rule (3 years of profits in a 5-year period), you can still prove your profit motive using the following nine factors:
You carry on the activity in a businesslike manner,
The time and effort you put into the activity indicate you intend to make it profitable,
You depend on income from the activity for your livelihood,
Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
You change your methods of operation in an attempt to improve profitability,
You, or your advisors, have the knowledge needed to carry on the activity as a successful business,
You were successful in making a profit in similar activities in the past,
The activity makes a profit in some years, and how much profit it makes, and
You can expect to make a future profit from the appreciation of the assets used in the activity.
It's not really clear in the article what she has done as they're focusing more on the emotion of the situation than the facts, but I would guess in their opinion she did not make the case above to be exempt of the 3/5 rule and thus avoid falling into "hobby" status.
Our federal tax code is a disaster, and this is only one small way by which it's playing out. The US Federal Tax Code in 1913 was 400 pages. In 2013 it's 73,954 pages; unfortunately for Ms. De Mars and the rest of us unless you have the means to engage a small business tax professional you potentially can fall into this trap as well if you're not careful.
@ Matthew -
So, the answer for an artist, to protect them selves, it form a LLC? Incorporate in some way that strongly identifies themselves as a business?
The best solution for most independent artists is likely an S-Corp as opposed to an LLC. LLC and C-Corp expenses are not deductible on your personal return - you need to file a separate return for your business. All expenses (and revenues) for an S-Corp are filed with your personal return, and as such a lot easier for most to manage.
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