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Your
Music:
A Business or a Hobby?
by Mark Fox, Fox Tax Service, July 2005.
Back to The
Academy
We all want to make a living doing something we enjoy. For most artists,
making money isn't the central goal, and running a business isn't even a
concern. However, success in creating and disseminating your work requires
certain business-like considerations. The first question for yourself (and the
first thing the IRS will be interested in knowing) is whether or not your art is
a business or a hobby.
Most artists do not make a profit, and incur losses for great spans of time.
You are allowed to deduct these losses on your tax return, but only if you can
show that you are carrying on the activity for profit, or the attempt at
profit.
The following is a list of factors that the IRS considers in determining
whether or not you are a for-profit business:
- You carry on the activity in a business-like manner,
- The time and effort you put into the activity indicate you intend to make it
profitable,
- You depend on income from the activity for your livelihood,
- Your losses are due to circumstances beyond your control (or are normal in
the start-up 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 the amount of profit that it
makes,
- You can expect to make a future profit from the appreciation of the assets
used in the activity.
Not all of these must pertain to you, but you should be able to show that you
are trying to make a profit and that you are running things in a business-like
manner. The best way to do this is to BE ORGANIZED, keep track of your income
and expenses. Poor to none in record keeping is a good sign that the IRS can
classify your art as a hobby and disallow any losses you may try to take. With
very little effort, you can avoid this. Check out the Creative Tax Planner
that we have designed to aid you in your effort to be organized.
Another easy way to show your determination as a for-profit business is to
take the time to establish the proper business entity for your art. To do so
shows that you are serious about being successful (and yes, you still need to
keep good records!). Please see the article on choosing a business entity type
(link to business entity page) for more info on this subject.
NOTE: Although the above focuses on artists, the same rules apply to any
business that may incur losses for numerous years.
Busines
Entities
An important issue facing all new businesses is choosing the proper business
entity type, a decision that impacts tax reporting requirements and liabilities.
In learning about and choosing the proper business entity, you will also learn
how to best view your business endeavor, simplify and understand its business
aspects, and minimize your tax liabilities. The following will be a short
overview of the most common entity forms. (For more information, feel free to contact us or visit the IRS website overview of Starting
a Business)
- Sole Proprietorships
A Sole Proprietorship is an unincorporated single owner business. It is not
separate from the individual. If you have not set up another business type, your
business venture is a sole proprietorship. This is the simplest form of business
to run. Your income and expenses are filed as part of your personal tax return
on a Schedule C.
- One disadvantage to a sole proprietorship is in regards to liability. Your
personal assets are at risk for your business liabilities. If this is an issue
for you (living in the land of lawsuits as we do), you may want to consider a
business entity that affords you certain liability protection.
- Partnerships
- A partnership is similar to a sole proprietorship, but contains multiple
owners. It is possible for several sole proprietors to share certain expenses,
e.g., co-leasing an office, without establishing a partnership; however, when
income and expenses are shared, a partnership exists and should be reported as
such.
- A partnership files a separate Form 1065 Partnership tax return, and the
profit or loss then flows through to each partner's personal return, based on
percentage of ownership. It is advisable to have a written partnership agreement
that determines the percentage of ownership and profit/loss sharing.
- A partnership also faces the same dangers of personal liability as a sole
proprietor. Recently, many people prefer to form an LLC instead.
- Limited Liability Company (LLC)
- An LLC is a newer type of business entity, allowed by state statute. LLCs
are popular because they combine the benefits of the simpler reporting
requirements and the flow-through characteristics of sole proprietorships and
partnerships with the limited personal liability for the debts and actions of
the business (like a corporation).
- A single-owner LLC reports income and expenses on a schedule C, like a sole
proprietorship. Multiple member LLCs report on the Form 1065 Partnership Tax
Return (unless an election for treatment as a corporation is made).
- Corporations
- The traditional corporation is a "C" Corporation. It is a completely
separate entity from its owners. It files AND pays its own tax. You would become
an employee of your corporation, and receive a W-2 for work done. Any profits
taken from the corporation would first be taxed to the corporation and then
again to you personally as dividends. Reporting and record-keeping requirements
are stricter than for other entity types. This type of entity is advisable for
very large, highly profitable ventures, especially when start-up capital is
required and you need to bring on investors.
- S Corporations
- An S Corporation avoids the double taxation of the C Corporation. It reports
income and expenses similar to a C Corp, but does not pay its own tax. Instead
the profit or loss flows through to the owners' personal returns, more like a
partnership. There are requirements to pay wages to the owners (if work is being
done and company is profitable), making the reporting requirements more
difficult than that of a partnership or LLC; however, there are certain tax
advantages to an S corporation, especially one that is profitable.
This is a very limited overview of business entity types. We suggest you do
further research or talk with a tax and/or legal professional prior to forming a
corporation or partnership. Each situation is different, and each business
entity has its advantages and disadvantages. The individual business owner has
the most freedom to choose from the simplest to the most complex business type,
depending on their situation, profits/losses, and potential liabilities.
We would like to add a little more concerning any artistic group, and
specifically bands. Most non-signed bands do not have any type of entity formed.
They are just a group of musicians who play together, make records, and hope to
cover their own expenses while waiting for the Golden Ticket to drop from the
sky in the form of a major label deal. This is fine, but becomes complicated by
income reporting requirements. If you are sharing all income and expenses, then
you essentially have a partnership and should report yourselves as such.
Usually, however, one member of the band tends to take care of the finances, and
the rest just want to show up and play. If this is the case, then you may either
form a partnership OR that one member, as the leader, should collect and track
all the income for the group, pay for the shared costs of recording,
advertising, etc., and then give out 1099-Misc. forms to the other members of
the group at the end of the year for their service (if there is any profit left
after expenses). - (Mark Fox is an IRS-certified Enrolled Agent with over 6 years of
full-time tax
preparation experience at one of Minnesota's largest independent tax offices.
For assistance with your tax situation, contact Mark at Fox Tax, LLC, via the
Fox Tax web
site, by calling 612-824-2829
or email.
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