Does the taxman hate the arts? Or just kittens?

May 1st, 2013 by Joe Kristan
20110202-2

Flickr image of Norwegian Forest Cat courtesy don.banane under Creative Commons license.

Do tax authorities hate the arts?  Megan McArdle, in The Taxman Cometh, explains that the tax man is just fine with artists — to a point.

She discuss a sad story in Minnpost.com about a artist couple who have been battling over “hobby loss” issues with the Minnesota Department of Revenue.  The story quotes one of the artists:

The tone of all these proceedings have  been completely anti-art. There has been an emphasis on creating a product, advertising it for sale, and then selling it. That’s not how it works on the creative end of literature. Writers need to spend a long time writing, getting feedback, moving up the levels of critique, and then they participate in the publishing industry by sending things out to publishers. One tries for the prominent ones first, gets rejected many, many times, and eventually finds a press and an audience.

Ms. McArdle thinks the problem isn’t an aversion to art: it’s that “the couple in question are not actually making any money:”

Business expenses are not supposed to be subsidies for doing something we think is important or valuable. (We do have some of those items in the tax code, too, but Schedule C is not where they normally go.)  Business expenses are supposed to be the expenses necessary to generate the profit upon which you pay taxes to the government. 

The tax department will disallow your expenses if the auditor deems that 1) the expenses are unnecessary to making a profit or 2) there is no profit.

Close.  She’s completely right that business expendutures must be, as the law puts it “ordinary and necessary” for the business.  That’s why, for example, an accounting firm might have difficulty deducting expenses for an executive dirigible.

Saying that there is no deduction if “there is no profit” overstates the case.   It’s the taxpayer’s “intent” to make money that counts.

Plenty of businesses come and go without ever making a dime, but their expenses may still be deductible.  Trouble starts if the losses go on and on, with no obvious prospect for a turnaround — but with continuing prospects for sheltering other taxable income of the business owners.  A classic example is the West Des Moines case of a couple who raised Norwegian Forest cats.  Over three years the taxpayer claimed less than $3,000 in revenues while deducting over $190,000 in cattery expenses.  This offset taxable income from a separate profitable IT consulting business.

The Tax Court judge explained the tax law rules (my emphasis):

Thus, the issues in the final analysis turn upon the question of whether  during the years in question the petitioner and the corporation had the requisite intent or motive of making a profit. Intention is a question of fact to be determined not only from the direct testimony as to intent, but a consideration of all the evidence, including the conduct of the parties. The statement of an interested party of his intention and purpose is not necessarily conclusive.

In other words, talk is cheap. It’s what you do that matters.  If you continue to adjust your business to find a way to make profits, trim unprofitable lines, keep good records, and follow a reasonable business plan, the tax law cuts you some slack, even with multiple loss years.  If at a reasonable point you realize you aren’t going to make money, close the doors, and cut your losses, you probably are fine.  But if the losses go on forever with no changes in the business plan, while reducing taxes you would otherwise pay on other income, expect the tax authorities to get upset.

To me the most interesting thing about this article is that, like in Iowa, Minnesota tax officials are raising hobby loss issues on their own.  States usually limit themselves to examining state-only issues, like residency.  As states become more desparate for revenue, we can expect more of this.

As for supporting the Arts, we staked out our vision of what the tax law can do back in 2005.

Related: IRS.gov,  Is Your Hobby a For-Profit Endeavor?

Share

Tags: ,