How to Classify Activities for Tax Purposes
Form 1099 reporting is not relevant to this determination
Taxpayers engage in various activities, such as performing services or selling goods, that generate gross income. The correct tax law classification of these activities is essential to determine the federal tax characteristics of the income and expenses that flow from them. This classification can be challenging as it requires applying more sophisticated tax law concepts against the taxpayer’s particular circumstances.
An activity will fall into one of three broad federal tax categories:
A trade or business activity,
An activity engaged in for profit, or
An activity not engaged in for profit.
Trade or Business Activity
The Internal Revenue Code has dozens of provisions that apply to trade or business activities without defining a trade or business.
There are many benefits to being a trade or business activity. For example, trade or business activities can deduct §162 ordinary and necessary business expenses along with other expenses above the line as an adjustment to income under §62(a)(1), and their owners are eligible for the §199A qualified business income deduction on the net income from the trade or business activity.
The main downside to being a trade or business activity is that most are subject to self-employment tax under §1402 unless otherwise excluded.
The Supreme Court in Comm. v. Groetzinger, 480 U.S. 23 (1987) promulgated guidance on what constitutes a trade or business activity:
Of course, not every income-producing and profit-making endeavor constitutes a trade or business. The income tax law, almost from the beginning, has distinguished between a business or trade, on the one hand, and "transactions entered into for profit but not connected with . . . business or trade," on the other…
We accept the fact that, to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity, and that the taxpayer's primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.
In Higgins v. Comm., 312 U.S. 212 (1941), the Supreme Court emphasized that the taxpayer’s specific facts and circumstances are essential to this determination:
To determine whether the activities of a taxpayer are "carrying on a business" requires an examination of the facts in each case.
In Service Center Advice 200120037, the IRS opined that almost all rental activities rise to the level of a trade or business activity under existing case law:
Where it is clear from the facts that real estate is devoted to rental purposes, the courts have repeatedly held that such use constitutes use of property in a trade or business, regardless of whether or not it is the only property so used. Curphey v. Commissioner, 73 T.C. 766 (1980); Fegan v. Commissioner, 71 T.C. 791, 814 (1979); Elek v. Commissioner, 30 T.C. 731 (1968); O’Madigan v. Commissioner, 19 T.C.M. 1178 (1960); Lagreide v. Commissioner, 23 T.C. 508 (1954); Leland Hazard v. Commissioner, 7 T.C. 372 (1946). This result is not changed by the fact that the taxpayer leases property to the taxpayer’s wholly owned corporation.
In General Counsel Memorandum 38779, in which the IRS Office of Chief Counsel addressed concerns about the IRS’s acquiescence to the Hazard case in which the Tax Court held that a single residential rental activity could rise to a trade or business activity, the IRS stated the following:
For these reasons, we question whether a change in Service position in this area is advisable. The problem that you raise is not with the legal standard applied by the courts, but with the relatively small amount of activity that the courts have found to be indicative of a trade or business. In view of the number of cases that have been decided on this issue, only some of which have been cited above, it is unlikely that the Service could now persuade the courts to take a more restrictive approach with respect to the amount of activity required to find that a taxpayer's rental activity constituted a trade or business… At most, it has been cited for the fact that rental of even a single piece of property may be a trade or business, a proposition with which we do not disagree. Thus, we believe that withdrawal of the Hazard acquiescence would have little effect on future cases.
Trade or business activities subject to self-employment tax, including rental activities where substantial services are provided, are generally reported on Schedule C, Profit or Loss From Business, or Schedule F, Profit or Loss From Farming.
Most rental activities are exempt from self-employment tax; those that are also trade or business activities are reported on Schedule E, Supplemental Income and Loss.
Activity Engaged in for Profit
An activity engaged in for profit lacks the regular and continuous involvement required to rise to the level of a trade or business activity.
Deductions for activities engaged in for profit fall under §212(1) or §212(2):
In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year—
(1) for the production or collection of income;
(2) for the management, conservation, or maintenance of property held for the production of income; or
Per Treas. Reg. §1.67-1T(a)(1)(ii), §212 deductions are generally miscellaneous itemized deductions subject to the 2% of AGI floor; therefore, they are nondeductible for federal purposes through 2025 (though some states still permit them). However, §212 deductions attributable to property held for the production of rents or royalties are allowed above the line as an adjustment to income under §62(a)(4).
Activities engaged in for profit are not subject to self-employment tax, and they are not eligible for the §199A qualified business income deduction.
Activities engaged in for profit generally report their gross income on Schedule 1, Additional Income and Adjustments to Income, line 8z. However, if it is a rental or royalty activity, the income and the expenses are reported on Schedule E, unless it is a personal property rental. For personal property rentals that are engaged in for profit but do not rise to the level of a trade or business, the income is reported on Schedule 1, line 8l and the expenses are reported on Schedule 1, Line 24b.
A Tax Court case that clearly demonstrates an activity engaged in for profit is Batok v. Comm., T.C. Memo. 1992-727. In this case, the Tax Court had to determine whether Mr. Batok’s side income was subject to self-employment tax, which turned on whether or not his activity was a trade or business activity:
Sometime during 1988, petitioner was informed by a friend that M. David Paul & Associates (M. David Paul) needed someone to help install office windows. Prior to accepting this job, petitioner had never engaged in this type of work. The job lasted for approximately 1 month, for which petitioner received compensation in the amount of $4,124.19. In early 1989, M. David Paul issued petitioner a Form 1099-MISC, reporting the $4,124.19 as non-employee compensation…
We believe that petitioner's installation of windows for M. David Paul does not rise to the level of a trade or business. Petitioner's activity, although engaged in for profit, was neither continuous nor regular. Petitioner had never installed windows prior thereto nor at any time thereafter. Rather, petitioner's activity was a "one-time job". Sloan v. Commissioner , T.C. Memo. 1988-294. Accordingly, petitioners are not liable for self-employment tax on the compensation received from M. David Paul.
Because Mr. Batok’s activity did not rise to a trade or business (and he kept poor records), he was ultimately not able to claim any deductions against the income:
Although petitioner's activity of installing windows fails to rise to the level of a trade or business, deductions are still allowed for the ordinary and necessary expenses incurred for the production of income… Thus, petitioners' itemized deductions, including any section 212 deductions, would need to exceed $5,000 to have any tax impact…
Petitioner has failed to substantiate many of the expenses claimed, as he has kept no records and has presented no substantiating evidence, such as receipts or cancelled checks… The only expense which petitioner has adequately substantiated is $124 for tools. Therefore, petitioners have not substantiated any deductible expenses in excess of their allowed standard deduction.
Activity Not Engaged in for Profit
Activities not engaged in for profit are governed by §183, the so-called “hobby loss rules.” §183(c) defines an activity not engaged in for profit as all activities other than §162 trade or business activities, §212(1) activities, and §212(2) activities (i.e., the ones described previously in this article).
Treas. Reg. §1.183-2 provides nine factors to be considered when determining if an activity is engaged in for profit:
Manner in which the taxpayer carries on the activity,
The expertise of the taxpayer or his advisors,
The time and effort expended by the taxpayer in carrying on the activity,
Expectation that assets used in activity may appreciate in value,
The success of the taxpayer in carrying on other similar or dissimilar activities,
The taxpayer's history of income or losses with respect to the activity,
The amount of occasional profits, if any, which are earned,
The financial status of the taxpayer, and
Elements of personal pleasure or recreation.
Gross income from activities not engaged in for profit is reported on Schedule 1, line 8j. The cost of goods sold for property sales reduces the gross income amount under Treas. Reg. §1.183-1(e).
§183 deductions are generally miscellaneous itemized deductions subject to the 2% of AGI floor, and they are only deductible to the extent of gross income from that activity. Similar to §212 expenses, they are nondeductible for federal purposes through 2025 (though some states still permit them).
§183(b)(2) provides for an exception to this rule: if a deduction would be allowed regardless of the status of the activity, it will be allowed under that provision and not as a miscellaneous itemized deduction subject to the 2% of AGI floor. For example, if a taxpayer rents their residence without a profit motive, the mortgage interest and real estate taxes allocable to the rental period can be deducted on Schedule A.
Activities not engaged in for profit are not subject to self-employment tax, and they are not eligible for the §199A qualified business income deduction.
Form 1099 Does Not Determine the Treatment
The type of Form 1099 received by the taxpayer has no bearing on an activity’s classification. The payer lacks sufficient information to determine the taxpayer’s involvement level and profit motive in their own affairs.
If a payer reports income on Form 1099-NEC, Nonemployee Compensation, it is true that the IRS’s computer assumes that it should be reported on Schedule C and subject to self-employment tax, possibly leading to a notice proposing a self-employment tax assessment if this not the case. This does not change the tax professional’s responsibility to correctly report the activity on the tax return. The creation of a false Schedule C activity with no net income to trick the IRS computer into not sending a notice to the taxpayer is inappropriate.
If the IRS does send a notice related to Form 1099-NEC, the taxpayer or their tax professional should simply respond with sufficient information to demonstrate the activity is not a trade or business activity subject to self-employment tax.
Ultimately, the IRS cannot simply rely on Form 1099-NEC or any other information return in making a determination with respect to the taxpayer’s activity. §6201(d) requires the IRS to provide additional information in certain cases when relying on an information return for a proposed deficiency:
In any court proceeding, if a taxpayer asserts a reasonable dispute with respect to any item of income reported on an information return filed with the Secretary under subpart B or C of part III of subchapter A of chapter 61 by a third party and the taxpayer has fully cooperated with the Secretary (including providing, within a reasonable period of time, access to and inspection of all witnesses, information, and documents within the control of the taxpayer as reasonably requested by the Secretary), the Secretary shall have the burden of producing reasonable and probative information concerning such deficiency in addition to such information return.
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Great analysis very helpful
In 2024 I have a client that formed a California LLC with 4 other persons to put on a festival in a town. Each person put in $50,000. It is a 2 day festival. The LLC will be cancelled once the festival is done. This article is making me think - because this is something this person has NEVER done before (he has 2 other businesses totally unrelated) and it is only for 2 days - this is not a business with continuity or regularity. Would this business be considered an activiy engaged for profit instead of a trade or business even though it is an LLC beiing taxed as partnership? and not subject to SE? OR what if they have a big LOSS can it be deducted? Being a partnership could the IRS classify it as an activity engaged in for profit and not a trade or business? Would love people's thoughts on this??