Since this is my first time posting on There Are No Wyverns in this Story allow me to introduce myself. My name is Nicholas Ritch, if the last name sounds familiar it is because I have the pleasure of being married to the creator of this blog, Erin Ritch.
I work for a tax, accounting and payroll firm in Oregon. I have been thinking about some possible business content for Erin’s fellow self-published authors that follow nowyverns.com for a while now and what better time than a week before tax season to start talking about taxes? One of my favorite business topics! This will be an ongoing series, I’ll cover a variety of topics and if you have a specific topic you have questions about in a future post leave it in the comments, I am happy to get suggestions!
Disclaimer: I am not a writer, my writing is flawed, overly technical and might give you a headache. I tried to make things clear but if you have questions or need clarification, please feel free to comment below and I will respond asap. I apologize in advance, I hope you find it helpful. 🙂
Now on with the show!
Is this a business or a hobby?
This is the most important question we need to answer before preparing a tax return for a self-published author.
If your self-publishing activity is a business, you will record your income and expenses on Schedule C, businesses can record losses that reduce your adjusted gross income. Businesses claiming income on schedule C will be subject to self employment tax when there is a profit.
If your self-publishing activity is a hobby, you will record all income on line 21 for miscellaneous income on the front of Form 1040; your expenses will be recorded as miscellaneous itemized deductions on Schedule A line 23. Only expenses above 2% of your adjusted gross income will be counted toward your total itemized deductions and your reported expenses can not exceed your reported income.
Of the two options listed above, having your activity classified as a business is definitely the most straight-forward and the ability to have losses offset other forms of income can be a great asset. But, income from a business is subject to self employment tax (15.3% of business gain, 12.4% is social security tax and 2.9% is medicare tax) in addition to any income tax that may result from adding it to your adjusted gross income.
If self-publishing is a hobby for you the income just gets added to your adjusted gross income, no self-employment tax. While you do get to claim expenses on hobby income on your schedule A itemized deductions, the deduction is limited to the amount of your income. The expense is further limited because only the amount of the expenses that exceed 2% of agi will be added to your itemized deductions. It is possible that your itemized deductions will be less than the standard deduction, in which case the expense doesn’t matter because the standard deduction provides greater tax benefit.
According to IRS Publication 535 there are a number of factors that may determine whether you are participating in a hobby or a business. Here is an excerpt:
“In determining whether you are carrying on an activity for profit, several factors are taken into account. No one factor alone is decisive. Among the factors to consider are whether:
- 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 the income for your livelihood,
- Your losses are due to circumstances beyond your control (or are normal in the startup 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 You can expect to make a future profit from the appreciation of the assets used in the activity.”
-IRS Publication 535: Business Expenses (2014), page 5
As we can see there are a number of questions you must ask yourself about your writing to make the determination of whether you may treat your writing as a business or a hobby. One of the things the IRS puts the most weight on in the determination of hobby vs business is what it calls “the presumption of profit.” Here is the IRS once again:
“Presumption of profit.
An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least 2 of the last 7 tax years, including the current year. The activity must be substantially the same for each year within this period. You have a profit when the gross income from an activity exceeds the deductions.
If a taxpayer dies before the end of the 5year (or 7year) period, the “test” period ends on the date of the taxpayer’s death.
If your business or investment activity passes this 3 (or 2) years-of-profit test, the IRS will presume it is carried on for profit. This means the limits discussed here will not apply. You can take all your business deductions from the activity, even for the years that you have a loss. You can rely on this presumption unless the IRS later shows it to be invalid.”
-IRS Publication 535: Business Expenses (2014), page 5
If your writing can meet this test, according to the IRS you have a “presumption of profit” and therefore you may treat the activity as a business. However, if your business does not meet this test it does not mean that you must immediately consider your writing activities as a hobby.
If you feel your writing business meets a number of the requirements in table 1.1 you may be able to argue that regardless of the years-of-profit test you are running a business. Just make sure you know your position and keep any documentation or proof that supports your claim to be treated as a business in case of a dreaded IRS letter questioning your claims.
The IRS leaves the decision up to the taxpayer, but it is the responsibility of the taxpayer to defend their position if your business losses are called into question because the IRS thinks your business should have been considered a hobby for tax purposes. This is where knowing what kinds of things the IRS uses to determine business vs hobby comes in handy.
Here are some things you can do to help legitimize your self-publishing endeavors as a business:
- Register your business in your state, to establish your business name – Some places call this a DBA filing or Ficticious Business name. Should be around $50, but costs vary from state to state as do renewal periods.
- Apply for an Employer ID Number with the IRS – This provides a number of functions but primarily gives you a tax id number for your business. If you are doing something in your business name that requires you to give a tax ID number you can give this EIN so you don’t have to give out your social security number. It is totally free and can be done online here: https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Apply-for-an-Employer-Identification-Number-(EIN)-Online)
- Get a business bank account – After establishing your business name and attaching the EIN to it you can open a bank account in the name of your business. Having your business name on the account will allow you to deposit checks made out to you in the name of the business. It is also important to keep your business and personal finances separate which is the main function of your business account. It will usually take a minimum $100 deposit to open, but policies vary depending on the institution.
- Make a business plan – the Small Business Administration has an awesome step by step walk-through for creating a business plan here: https://www.sba.gov/writing-business-plan
- Double entry accounting software- I highly recommend purchasing some sort of double entry accounting software like quickbooks (it doesn’t have to be quickbooks, but that is just what I use and am familiar with) to keep track of your income and expenses. This type of accounting software will also allow you to generate your main financial statements: the balance sheet, profit & loss, and cash flow statement. To compare intuit accounting products: hobbies use quicken, businesses use quickbooks.
If you decide your self-publishing activity is a hobby that you do for fun, that’s totally okay. Your status as a hobby vs business can always change in the future, when it does you may begin filing your taxes as a business. Arguing hobby vs business does not dictate the validity of your activities, it only dictates how we must proceed with regards to reporting income and expenses for tax purposes.
For more information on this topic I recommend looking at IRS Publication 535. It has not yet been updated to reflect the 2015 taxes we will be doing this tax season but should be shortly. Here is a pdf link to the 2014 pub https://www.irs.gov/pub/irs-pdf/p535.pdf
Disclaimer: The information contained in this post is not intended to be, and should not be, construed as legal, accounting or tax advice to the reader. This post contains my personal opinions and interpretations of the IRS tax code and the laws that govern it. It is also not intended to be specific, directed tax advise.
IRS Circular 230 Notice. This website/blog site is not intended or written by Nicholas Ritch to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.