Barely Legally

Confessions of a Moot Court Bailiff

Lights! Camera! Transaction!

I heard about an interesting case on Clusterflock the other day. A tax dispute between the IRS and a documentary filmmaker has sparked some minor outrage. Based on what I’ve read, the case revolves around whether making documentaries is a profit-making enterprise; if it is not, then the filmmaker can’t deduct her expenses related to making her film. Or her previous films – she’d owe hundreds of thousands of dollars in back taxes and penalties.

The executive director of the International Documentary Association has released a statement strongly condemning an interesting misinterpretation of the issue in the case:

In a US Tax Court trial held in Arizona on March 9, Judge Diane Kroupa made a statement that, if memorialized in a ruling, will have a devastating impact on independent documentary filmmakers across the US. Judge Kroupa questioned whether a documentary could be “for profit,” since by its nature it is designed “to educate and expose,” and she invited the parties to present case law on the issue.

Judge Kroupa’s speculation came in a case in which the IRS argued that filmmaker Lee Storey could not deduct business expenses pertaining to her film Smile ’Til It Hurts: The Up with People Story because the primary purpose of her film (and by inference all documentary films) is to educate and expose, not to make profit, and that therefore documentary filmmaking is a not-for-profit activity.

The IRS believes that if the person has no intent to make a profit, then the activity is a “hobby.” Therefore, they claim that Storey owes hundreds of thousands of dollars in back taxes and penalties for the business deductions she took.

The potential affirmation of Judge Kroupa’s statement could have a serious impact on documentary filmmaking […], bringing about audits and demands for back taxes because of a characterization of documentary filmmaker as meriting nonprofit status. To support Storey, IDA has filed an amicus brief in the case, urging the US Tax Court to recognize that the production of a documentary film is, at its core, a “for profit” business such that business expenses are deductible for tax purposes.

(Emphasis added: this language is significant, but we’ll go into that later.)

Intro to Tax

I’ve read a lot of misplaced outrage, and it seems to be stemming from a lack of knowledge about tax law. Hobbies aren’t tax deductible? Come on, guys. Let’s back up a little bit and figure out where the IRS and Judge Kroupa are coming from. This is how I explain it to my tax students.

Income tax is calculated based on the amount of money you make in a year, except for money you spent on things that were really important. These things are so important that the IRS will just pretend you never had that money to begin with: like it was spoken for before you even got it.

For example, stuff like medical bills, college tuition, or money you donated to a charity are all exceptions to your income. People have to take care of their health, right? It’s not really an option. That $3,000 medical bill won’t count as income, so if you made $30,000 last year, the IRS will only tax you on $27,000 of it. This is how deductions work.

For the accountants and tax lawyers reading this, I'm aware that the $3,000 deduction will only be allowed to the extent that the $3,000 medical expense exceeds 7.5% of the taxpayer's Adjusted Gross Income. I'm going to simplify all personal deductions in this article by ignoring the applicable floor.

The Wide World of Deductions

It’s not just medical bills, too. One of the big ones is the deduction for business expenses. If your printing company spends $5,000 on printing supplies, you can deduct that $5,000 from your income that year. Just like medical bills are really important and the IRS pretends you didn’t make that money, the IRS thinks it’s really important that you spend money on your business to make money.

To me, the most interesting thing about the tax code is seeing what sort of behaviors are incentivized by offering deductions. My father got a deduction a couple years ago for installing new insulation in his attic because Congress decided to incentivize making your house more energy efficient. As mentioned before, you get a deduction for donating to a charity, because we incentivize giving to really good causes.

Likewise, business expenses are designed to incentivize people to open businesses and inject money into the economy running the business. If your new bakery is going to fail, it’s going to be because of the global economic depression you failed, not because you couldn’t afford your taxes. That’s the idea, at least.

Operation: C.R.E.A.M.

So that’s a very basic primer on how deductions work and why they exist. Getting back to our documentary example: the IRS is arguing, and apparently Judge Kroupa agrees, that Ms. Storey’s filmmaking is not a business because there is no profit motive.

Now we know that business expenses are generally deductible; what if we don’t require that there be an actual business to be involved? It doesn’t take a lot of imagination to come up with ways to exploit this deduction.

So, that shiny new iPhone you bought can be an expense for your imaginary technology consulting business, which has no customers and for which you’ve made no money ever. Deduct the full cost of the iPhone. That giant new TV is part of your indie theater business, which never sells tickets and has never made a penny at all. Deduct the full cost of your whole home theater system while you’re at it.

To claim you’ve got business expenses, it’s not unreasonable to require the taxpayer to have a business. But a business is an entity that is engaged in making a profit; that’s just the nature of our system. Unfortunately, the IRS called Ms. Storey’s filmmaking a hobby in the part I bolded at the beginning of this article.

Plan B: The Hobby Loss

Your little garden that costs you $200 in soil, seeds and tools every year? Unless you’re selling the fruits (ha!) of your labor, you’re probably not going to get to count that as a business.

All is not lost, however. The tax code also offers a limited deduction for expenses incurred in decidedly non-profitable ventures, which we called “hobby losses” in my tax class. Under §183, titled “Activities not engaged in for profit,” a deduction is offered for your silly little garden; but only to the extent that you made a profit on the hobby.

This is still pretty handy. Sure, you won’t get to deduct all $200, but you also won’t have to pay tax on whatever little money you made from selling your vegetables (presumably to coworkers or lost little children).

Vive Le Différence!

There’s no such limitation on business expenses: if your business is crappy and you lose money, you can deduct as much as your spreadsheets can handle, even if it reduces the rest of your income to zero. If your hobby is crappy and you lose money, you can only only deduct the amount of money you made from your hobby.

You spent $400 making socks in your spare time, and sold $30 worth of them on the internet? If the IRS thinks it’s a business, you have a $400 deduction. If the IRS thinks it’s a hobby, you have a $30 deduction.

Bringing It Home

So what does this mean for Ms. Storey? Obviously, if the filmmaking was a business, she’d be in great shape: every penny she spent she could deduct. And really, movies are undeniably a product. Lots of folks are in the business of making movies.

But what if our filmmaker’s work is deemed a hobby? How could that even happen?

Well, the tax code has a specific deduction for hobby losses, so she’d still be allowed to deduct some expenses. Depending on how much income she has from selling her documentaries, she might even be able to deduct most of her expenses.

Unfortunately, if she’s been doing this filmmaking part-time (working a regular job otherwise), and trying to call her filmmaking a business which consistently loses thousands of dollars a year because she sells almost no films? Then yes, she’s going to have a really hard time convincing the IRS that it’s anything more than a hobby.

It’s not necessarily an easy sell for Ms. Storey, but it gets much worse if she’s been losing large amounts of money year after year in her (hypothetically hobby) filmmaking and working a full-time job; then it just looks like she’s using a hobby to deduct all her income, regardless of where it comes from. But again, you can’t deduct any of the income from your job, no matter how much money you lose in your hobbies.

(Spoiler alert: Ms. Storey is actually a lawyer by day, and makes films in her spare time. I leave it as an exercise to the reader to determine whether this resembles the hobby scenario or the business scenario I sketched out above.)

I look forward to reading the final ruling, because this case will turn on specific facts about how Ms. Storey conducted her filmmaking. Hobbies don’t generally have employees. Hobbies don’t generally have balance sheets. Businesses generally involve an effort to market and/or distribute your products. Businesses have plans and tax ID numbers.

So is this a hobby? Is this a business? I’ll get the popcorn.