The mouse in the Coca-Cola bottle. The airplane passenger stuck to the airplane toilet seat by vacuum. Some astronomical number of empty cigarette packs that will buy a wheelchair for a Viet Nam veteran.

You know these urban myths. You know they are not true. You might even mock those who believe and spread them. “How could anyone be so foolish?”

The answer, I think, is that they focus on people’s insecurities, the tiny ones deeply buried, which never reach conscious notice. So they persist no matter how loudly and often they are debunked.

You may lack that inner fear of food contamination, or embarrassment before strangers, or not being able to afford vital medical equipment. But you probably do have that repressed concern that somehow the money you spend on your arts career year after year might not be tax deductible. One durable—even indestructible—myth attaches to this insecurity like a virus: “You have to show a profit three years out of five to be able to deduct your expenses.” Or its inverse variant: “If you show a profit three years out of five, the IRS cannot argue about your losses in the other two.”

Not true. Never was true. Not true. Never was true.

(Feel free to set that to music.)

And It’s Still Not True

Now, it is true that there is a federal tax rule involving businesses that sustain losses year after year. It is also true that this rule uses the term “three years out of five.” And that is about all the facts have in common with what you heard while waiting for an audition or over a beer.

The actual rule addresses the problem of distinguishing a business which chronically loses money from a hobby which produces some revenue (but not enough to cover its cost). Often, the only way to tell them apart is to figure out what the owner is trying to do. That is what this hobby loss rule says: that a taxpayer can only deduct losses from an activity “entered into for the purpose of making a profit.”

This puts the IRS in the difficult position of having its employees discern motivation and exercise judgment, two tasks for which most of them have neither training nor aptitude. The decision is based on “all relevant facts and circumstances”—itself a highly subjective phrase—and the regulations lay out a list of nine factors to consider. Two are irrelevant to the arts. The remaining seven are (in the IRS’s words): 1) “the manner in which the activity is conducted,” 2) “the expertise of the taxpayer or his adviser,” 3) “the time and effort the taxpayer spends on the activity,” 4) “taxpayer’s history of income or losses with respect to the activity.” 5) “the amount of profits, if any,” 6) “taxpayer’s [other] finances,” and 7) “elements of personal pleasure or recreation.”

The first three are points any struggling artist can nail. You work hard, you have a degree, and you keep painstaking (and often painful) track of what’s happening in your career.

The last one is what sets most performers’ alarm bells off, the sense that “it can’t actually be work if I’m enjoying it.” That, in turn, does tend to bother IRS personnel, since many of them really dislike their jobs and very few truly enjoy their work. But that is only one point of seven.

This leaves the three which touch on money. The reason the IRS looks at a taxpayer’s other finances is to measure the sacrifice involved in spending the money. A wealthy person who occasionally charters his yacht is in a different position from an actor working for a temp agency.

Getting Down to It

Now we are down to the two factors that rumors and myth claim to be dominant: whether there have been profits, and if so, how much. These have to be considered together, since the facts are so interrelated. I have seen people manipulate their spending, abandon legitimate deductions and even claim bogus income to show a tiny profit in some years as a way of legitimizing large losses in other years.

This brings us back to the “three years out five” phrase. (Bet you thought I was never going to get there.) What it says is that an activity which shows a profit three years out of five is presumed to be a business. It does not say that you must show a profit three years out of five to be considered a business; it does not say that an activity showing a profit three years out of five will be considered a business; it does not say that an activity showing losses three years out of five will not be considered a business.

The key word is “presumed.” If an activity shows a profit in three out of five years, the IRS bears the burden of proof that the activity is not a business should the matter go to court; otherwise, the burden of proof that the activity is a business is the taxpayer’s. Contrived, minimal profits make the IRS’s case much easier—indeed, they almost make the case for them.

Soft and Fuzzy

Always remember is that the seven or nine factors are not scored numerically. Meeting more than half of them does not guarantee a win on the hobby loss issue, nor does failing to guarantee a loss. They are given uneven, subjective weights based on their perceived relevance to the activity being considered.

Precisely because it is a subjective area, I have rarely seen the IRS raise a hobby loss question unless significant sums of money are at stake. Sadly, that alone rules out it being an issue for most performers. Of the cases that progressed far enough into the court system to make it into my reference books, most involve racehorses, yachts, aircraft or farms. I cannot find even one that involves a performer.

Something For Nothing!

That’s right, you can get something absolutely for free that you may find useful in going through the mound of receipts in your sock drawer. If you would like a free copy of my “Checklist of Potentially Deductible Items for Persons in the Arts,” just write, call or e-mail me at my office.

Are there money or tax questions you would like to see discussed in this column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or call 773/525-1778 (888/525-1778 toll-free outside the Chicago area) or e-mail greg@gregmermel.com.

Greg Mermel is a certified public accountant whose clients in the arts range from individual performers to major theatre companies and suppliers. He has also been known to produce theatre.

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