From guest blogger Helen Schussler, CPA
HOBBY INCOME VS. BUSINESS INCOME
If you produce art to sell you are in the art business. If you sell your art, you need to report your income to the IRS. For artists just starting out, the first hurdle is to prove you are in business, in other words, that you have a profit motive. This is important because if you do not have a profit motive, you are engaged in a hobby and “hobby loss” rules apply. The “hobby loss” rules are not tax advantageous.
I had a client who was a doctor and also played the bass. One year he organized a gig with his band at a local bar. He was paid $4k by the bar. Between paying for equipment rental, paying some of the musicians and other incidentals, the gig cost him a little over $4k. He was fine with that because he really was doing it just for the fun of it and was happy that at least it wasn’t costing him anything.
In January of the next year the bar sent him a Form 1099 showing non-employee compensation of $4k. The Form 1099 is an IRS form prepared by the person who paid you, in this case the owner of the bar. One copy of the form goes to the IRS and one copy goes to you. My client wasn’t concerned about the form because he figured no tax could be due on no income. He had netted less than zero income on the performance. He didn’t even mention it to me; the story came out when I was working on his tax return in February and called to ask about the Form 1099.
Music for my client was clearly a hobby, not a business. Although you can take deductions for the expense of a hobby, those deductions are limited and, sometimes, depending on your income, not allowed at all. You can never take a loss from a hobby. My client was very surprised to find out he owed $1k in tax on the $4k earnings from the gig.
If you engage in your art to sell it and make money you are in business and different rules apply. You are considered self-employed and file a Schedule C with your annual income tax return. Schedule C is the page of your tax return where self-employment income and expenses are reported. If expenses are greater than income you have a loss. The expenses are not limited and the loss is not limited. The loss can be used to reduce any other taxable income you have, for example wages you have from your day job.
In order to benefit from the self-employment rules and not fall under the hobby loss rules you need to be sure you really have a business going. Make sure you have a separate checking account and credit card that you use only for business expenses and that any earnings you make get deposited first into that business account. The IRS frowns on the commingling of funds. If you take money from your business account for groceries and from your personal account for paint supplies, it starts to look like a hobby. Worse is if you do not even have separate accounts to begin with.
Other ways to prove a profit motive is to exhibit your work, advertise it and of course, actually make a profit from it. An activity is presumed to be engaged in for a profit if it is profitable three out of five consecutive years. (For a new business the first two years may show deductible losses, but you should start showing a profit by the third year. If you don’t, you may still have a valid business; it just may be more difficult to prove.)
TAKE ALL YOUR DEDUCTIONS
Once you have established a profit motive, you want to get the benefit of all your deductions. The mileage deduction is often overlooked. If you have to drive for your business, keep a log of miles driven. I suggest keeping this piece of paper right in the car. Whenever you take a trip for your art, write down the date, the destination, the purpose and the number of miles driven. Each mile is a 55.5 cent deduction for 2012.
If you use part of your home as a studio or office you can take a deduction for that as well. The deduction is calculated based on the percent of square feet used for the business compared to the whole home. Just be careful, the space must be used exclusively for the business purpose.
Things you do for education or to stay current in your field are also deductible: ticket expenses to plays for a playwright, art periodicals, museum fees, etc. Other common deductions include travel, office supplies, art supplies, website maintenance, etc. Equipment you purchase, like a camera, is also deductible, but over time. You usually cannot deduct the entire cost in the year of purchase, but must depreciate the cost of big ticket items over the years you use them.
PAY YOUR TAXES
Now that you are up and running and clearly making a profit, you need a plan for paying your taxes. The IRS expects to be paid along the way. You generally can’t wait until your return is due on April 15th to pay your taxes. If you receive a Form W-2 as an employee, taxes are taken out and paid to the IRS over the course of the year. If you are self-employed, you are responsible for paying that tax to the IRS in four quarterly estimated payments. These payments can be made in equal installments and are due in April, June, September and January (not exactly equal quarters, but that is how the IRS does it.) So if you estimate that you will owe $2k in tax you should pay $500 each quarter.
You can also “annualize” and pay as you earn. That means if you make nothing from January through November, but do really well in December, you pay no tax estimates April, June and September, but pay all in the fourth quarter (January of the following year.)
The quarterly payments, of course, are estimates. As long as you pay 90% of the total tax due you will be o.k. and will not have to pay any interest or penalties when you file your return in April. The IRS also will not charge interest or penalties if you have paid in 100% (or 110% for higher earners) of the tax that was due in the prior year. So if you owed $5k in tax for 2011, and you have paid in $5k in tax in 2012, you may owe more in April, but you will not owe interest and penalties. You can find instructions for calculating the tax due here >>> f1040es.
THINK ABOUT RETIREMENT
Lastly, it is important for artists not to overlook retirement planning. If you file a Schedule C for your self- employment income as an artist, you can set up a SEP-IRA. You can set up a SEP-IRA even if you participate in a 401K plan at your day job. The tax advantage of having a SEP is you can take a deduction for the amount you deposit into the SEP account and the money grows in the account tax deferred. You don’t pay any tax until you take withdrawals when you retire. Withdrawals taken at retirement age will likely be taxed at a lower rate.
The amount you can deposit into a SEP-IRA each year depends on your self-employment income. For 2012, the maximum you can contribute is $49k or approximately 20% of your self-employment income, whichever is less. If you contribute to your 401K at your day job, total contributions for both the SEP and the 401K cannot exceed the $49k. So max out your 401K at work ($17k for 2012) and if you can afford to put any more away, put it in a SEP.
I hope this has been helpful. I have skimmed over these important topics to give you an introduction to the tax issues you may have to deal with. In my next blog I will discuss the tax implications of donating your artwork to charity and leaving artwork to your heirs. Please leave any questions; I will try to respond to everyone.
IRS Circular 230 notice: In order to comply with requirements imposed by the IRS, I must inform you that any U.S. federal tax advice contained in this blog is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter that is contained in this blog.
Great article it would also applies to similar conditions for Canadian residents with a few changesReplyDelete
Thanks Michel ... glad you enjoyed the tax tips for the art world and find them useful! My best, JuergenReplyDelete
Hi all, Just to be clear, these tax tips are for U.S. taxpayers only. I cannot speak to the tax laws of other countries. Let me know if you have any U.S. tax questions. I would be happy to answer them.ReplyDelete
Helen Schussler, CPA