22 TAXES: THE HOBBY LOSS CHALLENGE
Often the artist, sufficiently dedicated to pursue an art career despite year after year of losses on Schedule C, will face a curious challenge from the IRS: the losses incurred by the artist cannot be deducted for tax purposes because the artist was only pursuing a hobby and did not have the profit motive necessary to qualify the art career as a business or trade. A hobbyist in any field may deduct the expenses of the hobby only up to the amount of income produced by the hobby. For example, if a hobbyist makes $500 in a year on the sale of art, a maximum of $500 in expenses can be deducted. On the other hand, an artist actively engaged in the business or trade of being an artist—one who pursues art with a profit motive—may deduct all ordinary and necessary business expenses, even if such expenses far exceed income from art activities for the year.
A Test: Three Years out of Five
But how can an artist show that the requisite profit motive is present and avoid being characterized as a hobbyist by the IRS? At the outset, there is an important threshold test in favor of the taxpayer. This test is a presumption that an artist is engaged in a business or trade—and hence is not a hobbyist—if a net profit is created by the activity in question for three of five consecutive years ending with the taxable year at issue. Thus, many artists who have good and bad years need not fear a hobby loss challenge to a loss in one of the bad years.
If a hobby loss problem is anticipated, artists on the cash basis may be able to create profitable years by regulating the time of receipt of income and payment of expenses. For example, instead of having five years of small losses, an artist is far better off having three years in which a small profit is earned and two years in which larger than usual losses are incurred. Another way to create a profitable year is to sell art to a friend and buy some of the friend’s art. In essence a trade, this will lose some deductions but gain a profitable year (and also entitle the artist to hold the purchased art as a collector, which may have favorable tax consequences). If the artist has an art-related job, some daring accountants enter the wages from the job on Schedule C as income from the business of being an artist. While not recommended, an artist might wish to discuss this with his or her own professional advisors.
Profit Motive: The Nine Factors
But even if an artist does not have three profitable years in the last five years of art activity, the contention by the IRS that the artist is a hobbyist can still be overcome if the artist can show a profit motive. The Regulations to the Internal Revenue Code specifically provide for an objective standard to determine profit motive based on all the facts and circumstances surrounding the activity. Therefore, statements by the artist as to profit motive are given little weight. But the chance of making a profit can be quite unlikely, as long as the artist actually intends to be profitable.
The regulations set forth nine factors used to determine profit motive. Since every artist is capable, in varying degrees, of pursuing art in a manner that will be considered a trade or business, these factors offer an instructive model. The objective factors are considered in their totality so that all the circumstances surrounding the activity will determine the result in a given case. Although most of the factors are important, no single factor will determine the result of a case. The nine factors follow.
1. Manner in which the taxpayer carries on the activity. The artist should keep accurate records of all business activities, especially receipts and expenses.
2. The expertise of the taxpayer or his advisors. Study is one indication of expertise, but equally important is professional acceptance as shown by gallery exhibitions, encouragement by agents or dealers, the winning of prizes, professional memberships, or critical recognition in articles or books. Use of professional equipment and techniques can also be important. The appointment to a teaching position, if the appointment is based at least in part on professional artistic ability, further demonstrates expertise.
3. The time and effort expended by the taxpayer in carrying on the activity. The activity does not have to absorb all of the artist’s time, but a failure to work at all is not consistent with having a profit motive. Exactly what qualifies as sufficient time has never been spelled out, but on one occasion the court found four hours a day acceptable. It is helpful if the art activity is the only occupation of the artist, but employment in another field does not negate the presence of a profit motive with respect to art.
4. Expectation that assets used in activity may appreciate in value. This factor has yet to be applied to the arts, although artists, of course, expect that their art will increase in value.
5. The success of the taxpayer in carrying on other similar or dissimilar activities. Previous critical or financial success in art, despite an intervening slack period, is helpful.
6. The taxpayer’s history of income or losses with respect to the activity. Increasing income each year from the art activity is very positive. On the other hand, losses do not imply a lack of a profit motive, unless such losses continue over a lengthy time period during which income is being received from non-art sources and a large imbalance exists between art-related income and expenses. Paradoxically, the change of profession to a non-art activity after an unprofitable art career would also show that a profit motive had existed in the pursuit of the art activity.
7. The amount of occasional profits, if any, that are earned. Here the amount of profits is compared to the amount of expenses, but this factor is important only when the taxpayer is sufficiently wealthy to gain tax benefits from disproportionate expenses without feeling any financial strain from the amount of the expenses.
8. The financial status of the taxpayer. Wealth and independent income are unfavorable to having a profit motive, while the need for income from the art activity and the lack of funds to support a hobby would tend to indicate the presence of a profit motive.
9. Elements of personal pleasure or recreation. This has little application, since the pursuit of an art career is as painstaking and rigorous as any occupation. However, where travel is involved, the artist should be fully prepared to justify such travel in terms of its furtherance of the art business.
Cases
To give perspective to these nine factors, a look at three hobby loss cases will be helpful. In the first case, the tax court found the artist a hobbyist; in the second case, a professional artist. In the third case, the court found the artist to be a professional and focused on the factors that demonstrated the artist’s profit motive. These cases should serve as models for the artist because they illustrate the approach taken by the tax court in hobby loss cases.
Case 1: The Hobbyist
Johanna K. W. Hailman was a prominent social leader in Pittsburgh, Pennsylvania. Born in 1870, she had painted from an early age—mainly portraits and flowers—and by the time of her death in 1958 had completed five to six hundred paintings. She owned a large estate and received substantial income from investments and a trust established by her deceased husband. On her estate she had a fully equipped and heated four-room studio located about one hundred and fifty feet from her main house. During the winter, she maintained a room in her Florida residence for a studio. She was recognized as a leading artist in western Pennsylvania and had good standing throughout the United States. She had shown her work in the First International Exhibition at Carnegie Institute in 1896 and, apparently, exhibited at all the subsequent International Exhibitions at Carnegie through 1955.
Between 1920 and 1949 she sold about fifty paintings, but made no sales from 1949 to 1954. She did not use a dealer or agent, but offered her paintings for sale at various exhibitions in Pittsburgh and other places. In the 1950s, the prices paid for her paintings ranged from $700 to $1,500, and she refused to accept offers she felt would be inadequate to maintain her prestige as an artist. From 1936 to 1954 her income from painting amounted to $7,200, while her expenses incidental to making and selling paintings came to $131,140. The IRS did not allow all of these expenses, but instead adopted the practice through 1951 of permitting as a deduction the amount of $3,000 per year.
Though she stopped selling work in 1949, Hailman continued to incur expenses. In 1952, she had expenses of $9,654. An additional $7,718 in expenses were incurred in 1953, and another $6,457 in 1954. The IRS determined that none of the expenses in these three years should be allowed as deductions because Mrs. Hailman was not engaged in the business of being an artist.
The tax court agreed with the IRS. The court concluded that when, over a lengthy period such as 1936 to 1954, expenses are eighteen times as great as receipts from an activity, and only independent wealth permits the continuance of the activity, including the setting of high prices and the retention of most of the artworks, then the activity must be determined to be pursued for the pleasurable diversion provided by a hobby without the necessary profit motive for one engaged in a business or trade. The result was that no deductions were allowed for the years 1952, 1953, and 1954.
Case 2: The Professional
Anna Maria de Grazia, who painted under the name of Anna Maria d’Annunzio, was born in Switzerland. The granddaughter of Gabriele d’Annunzio, the famous Italian writer and military hero, she was raised in Italy where, in 1940, she became interested in painting. During World War II, she served as a guide for the Allied forces, continuing to paint during the war and even when, in 1944, polio forced her to learn to paint with her left hand. In 1942, she won first prize in an exhibition of young painters in Florence and in the same year placed third in a contest open to all Italians. She did not paint from 1943 to 1947 but did paint and exhibit from 1948 to 1951. During this period she was admitted to the Italian painters’ union upon the attestation of three professional artists that she was also a professional artist. In 1952 she moved to the United States, married Sebastian de Grazia, and neither painted nor exhibited until 1955, when she also became a naturalized citizen of the United States. By 1957, she had studied with artists Annigoni, Carena, and Kokoschka and was recognized by having her self-portrait and biographical background appear in a book on Italian painting from 1850 to 1950.
She resumed her painting in 1956 and 1957, supported by the modest income of her husband, who was a visiting professor at Princeton University. In 1957 she painted at Princeton in a rented house that she felt had inadequate facilities for a studio. Finally, in May, she left to paint at the Piazza Donatello Studios in Florence, Italy, which had been built for artists and had excellent light. Her decision to go to Florence was prompted by her familiarity with the Italian art world, and came after she had made several unsuccessful visits to New York in 1957 in an attempt to find an art gallery for her work. She painted four hours a day in 1957, devoting additional time to stretching and preparing her canvases and transacting business with art dealers and her frame maker. She had been told that a prestigious gallery in New York would require numerous paintings for an exhibition, and by the end of 1957 she had completed between twelve and fifteen paintings with ten more in progress. After 1957, she did exhibit successfully, having a number of solo shows in Italy as well as having her work exhibited in Princeton and New York City.
In 1957, she had no income from her painting, while her expenses were $5,769; in 1958, she had $500 in receipts, while her expenses were $6,854; in 1959, she had $575 in receipts, while her expenses were $5,360; and, in 1960, she had $710 in receipts, while her expenses were $4,968. She did not keep formal business books, but did have records relating to her receipts and expenses as an artist. The IRS challenged her deduction of $5,769 in 1957 on the grounds that she had been merely pursuing a hobby or preparing to enter a business or trade, but had not actively engaged in the business or trade of being an artist in that year.
The tax court, in an excellent opinion, disagreed with the IRS and concluded that she had indeed been in the business or trade of being an artist in the year 1957. The tax court found several facts that demonstrated Anna Maria de Grazia’s profit motive. She began painting in her youth and won prizes for her work. She struggled to overcome the handicap imposed by polio. She studied with recognized artists, and received recognition from the Italian painters’ union and in critical publications. She had exhibited both prior and subsequent to 1957. She worked continually and unstintingly at her painting and necessary incidental tasks. She had no other sources of income, and as such, her losses were a financial strain. Finally, she had constantly increasing receipts in the years after 1957. The tax court also explicitly rejected the argument that she had merely been preparing to enter a trade or profession, stating that the history of her art activities after 1940 rebutted any such contention. In a notable section of the decision, the court wrote:
It is well recognized that profits may not be immediately forthcoming in the creative art field. Examples are legion of the increase in value of a painter’s works after he receives public acclaim. Many artists have to struggle in their early years. This does not mean that serious artists do not intend to profit from their activities. It only means that their lot is a difficult one (Sebastian de Grazia, T.C.M. 1962-296).
Case 3: Finding the Profit Motive
In another case favorable to artists, a woman who had painted for twenty years without making a profit was found to have a profit motive. For the three years in which the IRS tried to deny her deductions, she had only one sale for $250. The tax court noted that she had made extensive efforts to market her work, including running a gallery for a year, keeping a mailing list, seeking other galleries, and making different efforts—such as making posters and writing books—to enhance the likelihood of sales. She kept a journal for sales and kept all her receipts. Also, she had studied and taught art. Her work did appear at least once a year in commercial galleries and she had been written up in newspapers and magazines. She had also received a grant to do a film. She devoted a substantial amount of time to her artistic activities.
In holding that the artist had a profit motive, the court wrote:
It is abundantly clear from her testimony and from objective evidence that petitioner is a most dedicated artist, craves personal recognition as an artist, and believes that selling her work for a profit represents the attainment of such recognition. Therefore, petitioner intends and expects to make a profit. For section 183 purposes, it seems to us irrelevant whether petitioner intends to make a profit because it symbolizes success in her chosen career or because it is the pathway to material wealth. In either case, the essential fact remains that petitioner does intend to make a profit from her artwork and she sincerely believes that if she continues to paint she will do so (Churchman v. Commissioner, 68 T.C. 696).
An Overview
Artists with wealth and independent incomes, whose art activity expenses are large relative to their receipts over a lengthy period, are most likely to be treated as hobbyists by the IRS. Artists who devote much time to their art, who have the expertise to receive some recognition, and for whom the expenses of art are burdensome, will probably qualify as engaged in a business or trade. Especially younger artists, who are making the financial sacrifices so common to the beginning of an art career, should be considered to have a profit motive, even if other employment is necessary for survival during this difficult early period.
Each case in which an artist is challenged as a hobbyist requires a determination on its own facts. However, being aware of the relevant factors a court would consider in imputing profit motive will help the working artist avoid being characterized as a hobbyist. It is advisable to have the professional assistance of an accountant or lawyer as soon as a hobby loss issue arises during an audit. Such professional advisors can be particularly helpful in effectively presenting the factors favorable to the artist. The presence of a lawyer or accountant at the earliest conferences with the IRS can aid in bringing a hobby loss challenge to a quick and satisfactory resolution.