Earlier this week, the New York Times ran a fairly breathless story about Susan Crile, an acclaimed artist, and the Tax Court’s decision regarding her problems with the IRS. Ultimately, the Times says, this case is A. Big. Deal. The Times‘s lede:
If you say you are an artist, but you make little money from selling your art, can your work be considered a profession in the eyes of the Internal Revenue Service?
Spoiler: the answer is yes. Spoiler that the Times is apparently unaware of: we’ve known that the answer was yes for a long, long time. That is, although the Times assures us that the case is “seen by many as an important victory for artists,”[fn1] they’re wrong. This is, at best, a marginal victory (that will ultimately lead to a loss) for Ms. Crile.
I’m not the only who thinks this case isn’t terribly groundbreaking: the Chief Judge of the Tax Court agrees. He designated the case a “Memorandum Opinion” rather than a “Tax Court Opinion.” The difference? A Memorandum Opinion is one that doesn’t involve a novel question of law; rather, the case is factually-driven.
Of course, to understand why I and the Chief Judge say that this isn’t a big deal, we need to dig into the law and the facts of the case. (And, by the way, you really need to read the case. Which I will link to again here. It’s a fascinating look at the finances of an acclaimed artist. A second spoiler: you don’t make money making art, even when your art is acclaimed.)
The Tax Court has two main questions in front of it: first, is Ms. Crile’s art a “trade or business” or is it a hobby?[fn2] Second, if it is a trade or business, is it a separate trade or business from her job as a professor of studio art at Hunter College?
Trade or Business
“Trade or business” is an essential term in the tax law—it appears dozens of times in the Code, and even more in the regulations—but it has not been formally defined. Essentially, though, a “trade or business” an endeavor into which a taxpayer enters (a) with the intention of making a profit, and (b) to which the taxpayer devotes sufficient time and effort.
Why does it matter whether her art was a trade or business or a hobby? Because of the treatment of expenses. With a trade or business, you can deduct all of your expenses associated with that trade or business (with a couple limitations, one of which I’ll discuss in just a minute). With a hobby, though, you can only deduct expenses to the extent your expenses don’t exceed your income from the hobby.
An example: imagine I earn $75,000 a year as a midlevel executive and, in addition, I raise horses. In 2014, I earn $20,000 selling the horses, but feeding them and housing them may cost me $50,000. If I’m in the trade or business of raising horses, I can deduct the full amount against my income: the expenses will reduce my horse-related taxable income to $0, and the additional $30,000 of deductions will reduce my taxable income from my salary to $45,000.
If, though, the IRS or the courts determine that I’m just in the hobby of raising horses,[fn3] I will only be able to deduct $20,000 of the expenses, reducing my horse-related taxable income to $0, but leaving me subject to tax on $75,000 of income.
So how about Ms. Crile? The Tax Court looks at a nine-factor balancing test and determines that the factors weigh in favor of treating her art as a trade or business. One factor, logically, is the taxpayer’s history of income or losses. (Remember, the New York Times‘s lede was that this resolved the question of whether an art career that makes little money can be considered a profession—it means a trade or business—for tax purposes.) And, the Tax Court says, this factor weighs against Ms. Crile. But, it goes on, this is only one factor among nine, and is not, alone, determinative. In fact, the Tax Court finds (rightly, and with plenty of precedent) that she is engaged in the trade or business of being an artist, and that, as such, her art-related deductions are not limited to the amount of income she earned selling her art.
One or Many?
The second question the Tax Court has to address is whether her artistic endeavors are a separate trade or business from her job as a professor of studio art. Note, again, that the law here isn’t new or controversial: clearly, a taxpayer can have two trades or businesses simultaneously. The only question here was whether Ms. Crile had two.
Why does she care?
Again, it’s all about the deductions. If her artmaking is part of her trade or business of being a professor, the amount she can deduct is limited (though not as limited as it would be if it were just a hobby). As a professor, she was an employee of Hunter College; an employee can be in the trade or business of being an employee. But unreimbursed expenses associate with the trade or business of being an employee are miscellaneous itemized deductions.
I don’t want to go too deeply into the weeds here, but miscellaneous itemized deductions face two limitations. First, they can only be deducted if and to the extent they exceed 2% of a taxpayer’s adjusted gross income.[fn4] Second, if she’s subject to the alternative minimum tax, she doesn’t get to deduct her miscellaneous itemized deductions. Which is to say, she’d much prefer that they were separate trades or businesses.
Which, the Tax Court says, they were. Although she had to create and display art for her professor job, it didn’t require her to actually sell art, but she put in the effort to sell it, which indicated to the court that her art was separate from her day job.
So What Was the IRS Thinking?
If the law is as clear as I claim it is, what was the IRS thinking?
I don’t have any insider knowledge, of course, but here’s what I suspect: Ms. Crile, great artist though she may be, was a tremendously aggressive taxpayer. In 2009, for example, she had gross receipts from her art of $6,525, but claimed trade or business deductions of $43,601.[fn5] And that’s the smallest difference between receipts and expenses she claimed over the five-year period laid out in the opinion.
Why did it cost her so much to create her art? I’ll let Judge Lauber explain:
Petitioner’s theory for claiming deductions seems to have been that most experiences an artist has may contribute to her art and that most people with whom an artist socializes may become customers or otherwise advance her career. The trial established that a significant number of the deductions she claimed were not, within the meaning of section 162(a), “ordinary and necessary expenses” of conducting her art business but were “personal, living, or family expenses” nondeductible under section 262(a). The latter expenses appear to have included telephone and cable television bills, newspaper and magazine subscriptions, gratuities to doormen in her apartment building, taxicabs to the opera, museums, and social events, restaurant meals with friends and acquaintances, and international travel to gain inspiration from paintings in European museums.
And that is why I indicated at the beginning that, ultimately, this case is at best a marginal victory, preceding an ultimate loss, for Ms. Crile. See, even though she is engaged in the trade or business of being an artist, that doesn’t mean every expense she incurs is deductible as such. The court put off, for this opinion, deciding which of her expenses are expenses incurred in her trade or business of being an artists, but clearly not all of them are. Ultimately, then, she took impermissible deductions, which lowered her tax bill. She will ultimately have to pay taxes on the amount of deductions to which she wasn’t entitled and, in addition, will likely owe interest and penalties. The only question is, how much?[fn6]
[fn1] Conveniently, though, it doesn’t mention who or how many those “many” are.
[fn2] “Hobby” probably isn’t the perfect term here. In fact, the Code and the Tax Court use the language of an activity “not engaged in for profit.” But in the tax profession, we refer to losses disallowed by section 183 as “hobby losses.”
[fn3] Which they almost certainly will: horse-related activities are almost always treated as hobbies, at least when engaged in by individuals who make their money doing something else.
[fn4] Quick numerical example: if my adjusted gross income is $100,000 and I have $3,000 of miscellaneous itemized deductions, I can only deduct $1,000, because 2% of $100,000 = $2,000, and my miscellaneous itemized deductions only exceed it by $1,000.
[fn5] Note that her job at Hunter paid her $106,058.
[fn6] Peter J. Reilly has some interesting thoughts on the case, too.