Determining Whether an Enterprise Is a Hobby or a Business - Example

Running header: Tax Law. Student’s name: Instructor’s name: Subject code: Date of submission: Tax law Determining whether an enterprise is a hobby or a business When making decisions regarding engagement in business, one will most likely choose a field that he/she really enjoys. Depending on how the enterprise is managed, the tax agencies may classify it as a hobby rather than a business. The difference between how the income from the two enterprises is reported is largely found in the expenses deductions and hence taxation as well as how the tax office will treat your losses from the enterprise. As far as losses treatment is concerned, one might be better of if the tax offices consider his/her enterprise a business although the tax office will tax income from both the enterprises at the same rate1. As such, there is need for one to be aware of the criteria used in determining whether his/her enterprise is a business or a hobby. Under common law, a business enterprise is viewed as any activity or enterprise entered into/ engaged in for profit. This is regardless of its form or size as it ca n range from a simple street peddler to a very big company. In other words, it is anything in which a person can engage in for gainful employment purposes or generation of profits. It is that activity that occupies a person’s time, attention and labor for the purpose of profit. As such, for the enterprise to qualify as a business, it has to be continuous implying that a single act that pertains to a particular business does not qualify as a business activity. On the other hand, a series of such activities carried out continuously and/or regularly will be considered business enterprises. It should however be noted that Labour and work is not synonymous to business since labor and work may or may not be business2. Based on the common law understanding of business, an enterprise will therefore not be considered a business if it is not carried out with a profit motive, it is not regular and if it is not continuous. As such, when classifying hobbies for tax purposes, they can be classified as hobbies or recreational activities that are not carried out with the sole aim of making profits or earning income although they may generate income from time to time. It is therefore important to note that the profit motif is of paramount importance in determining whether an enterprise is a business and hence accessible for business income tax purposes or a hobby in which case their expenses are not considered allowable expenses.3 Statutory rules regarding whether an enterprise qualifies as a business Subsection 995 of the ITAA 1997, defines a business enterprise in addition to issuing the criteria for determining whether a business is being performed. The section defines a business as including any profession, employment, trade, calling or vocation excluding occupation as an employee .The determination of whether an enterprise is a business will be based on the words of Gummow and Hayne JJ in FCT v Murray where they stated that a business is not a thing or things but a course of conduct carried on for the purpose of profit and involves notions of continuity and repetition of actions. The judge also stated that where an overall profit motive appears absent and the activity does not look like it will ever produce a profit; it is unlikely that the activity will amount to a business. It should be noted that the repetition stated above excludes an association formed for doing a particular act that is never to be repeated from being regarded as a business enterprise4. Furthermore, the high court in Spriggs & Riddell identified a number of indicia in determining the existence of a business. The factors that can be used in determining whether a business is a business and not a hobby are explained below; a) Does the enterprise have a profit making motive- for an enterprise to be regarded a business, it has to have the sole aim of making profits. In FCT v Stone, the judges held that if the enterprise has a view of profiting, the conclusion that the enterprise is a business will be easily reached. However, a detailed survey and exact scrutiny of the enterprise’s activities has to be carried out in concluding that the activities constitute carrying out of a business5. b) The scale of activities – although undoubtedly a relevant factor, it is not a determinative factor unlike the profit motive. Although activities may have a limited scale, this does not prevent their classification as business where other factors considered point to that conclusion as was held in Ferguson vs. FCT6. c) Organisation of the enterprise in business like manner and the use of system – The court in Newton v Pyke7 observed that a business is conducted systematically. Hence, an enterprise will be regarded a business if it is carried out in an organized and systematic manner as opposed to ad hoc basis. An activity therefore has to conform to the ordinary commercial principles if it has to amount to the carrying out of a business. d) Repetition and regularity-a business enterprise will carry out similar sorts of activities in a repeated and regular basis. As such, an activity that is carried out repetitively and regularly will not be considered a hobby but a business. This was the case in JR walker where the court held there was a repetition and regularity in his activities of breeding of high quality Angola goats8. Hobby For taxation purposes, the carrying out of a hobby is not the same as carrying out of a business. As such, income from a hobby will not be regarded as income for taxation purposes and is not accessable. In Ferguson at ATC 4265: ATR8779, it was said that “if what he is doing is more properly described as the pursuit of a hobby or recreation or an addiction to a sport, he will not be held as carrying out a business although his operations be fairly substantial.” An enterprise will be considered a hobby when; -when it is not the intention of the owner to make a profit from the activity and this is evident, -any losses from the activities are incurred with the motivation of personal pleasure but not of making a profit and no intention is there to show how profits can be made. -the activity is an isolated transaction with no repetition and /or regularity, -The enterprise’s activities are not carried out in the same manner as a normal/ordinary business activity, -There is no system for allowing profit to be made in the conduct of the activity -there is an intention by the owner to carry out a hobby and not a business, -The proceeds of the enterprise are not sold to the public at large. Leading cases regarding the status of an enterprise as a business or hobby: The cases below are used to explain the above statutory provisions that determine whether an activity is a business or a hobby. FCT v Norm Norm was a keen gardener who enjoyed growing vegetables in his garden and exhibiting larger specimens at vegetable shows for which he often won prizes. He had been doing this for the last twenty years. Norm always kept up with the latest advances in growing vegetables .However; he kept no records of his expenses. His only intention was to grow the biggest and best vegetables. Usually he gave away his broccoli and pumpkin to relatives and friends10. However, he found that in the last 12 months people approached him at the shows to purchase his prize winning specimens. He has been happy to sell these. The question was whether Norm was carrying on a business. Held: Norm’s activities amounted to a hobby since: - The size and scale of his activity was small, as it was in his backyard; - He had no plan or intention to make a profit and his activities were motivated by his passion for growing broccoli and pumpkins; - His produce was usually given away to friends and family rather than sold to the general public; and - Records were not kept and the activity was not carried on in the same manner as that of the ordinary business activity of commercial pumpkin and broccoli growers. FCT v Stone (2005) 59 ATR 50; 2005 ATC 4234: In this case, Ms Stone was a full time employee as a senior constable in Queensland police force in addition to being a leading Australian Javelin thrower. Ms Stone disclosed her earnings from both the sources but failed to report the grants from her athletic activities as assessable income and made no claim for deductions relating to the javelin throwing activity. However, the commissioner made an assessment for both the earnings claiming that the total receipt was assessable income for taxation purposes11. However, Ms Stone objected the commissioner’s assessment and referred the case to the court. In deciding the case, the court considered a number of factors including -what income is according to ordinary concept? -Whether the athletic activity was a business or a hobby? The judge held that the grants represented gains from an activity of business nature due to its regularity and repetitive nature. The grants represented reward for service performed and that the grants were gains that are compensation for an activity that had a character of income. As such, Stone was liable to pay tax on the grants awarded. FCT v Richard Richard was a musician and singer in a rock band. He was also interested in dressage and he bred horses to obtain better mounts for his dressage competitions. However, he usually sold any unwanted and untrained offspring .r. The sale prices were well below the expenses associated with maintaining the horses. He conducted research into breeding and training techniques and kept detailed records of breeding and all expenses associated with the horses12. The question was whether Richard carrying on a business of horse breeding? Held: Richard was not carrying out a business of horse breeding since: -Horse keeping was primarily motivated by the desire to compete and any returns were only incidental to this purpose, -No profit was made from the activity - He had no intention of making profit. Though he kept records, these were all associated with his dressage activities.  -the activity did not have significant commercial purpose or character. The following are the guiding directions issued by the ATO on whether an activity might qualify as a business or hobby: a) Does the activity have a significant commercial character? If yes, it is most likely a business. b) Does the owner have more than just the intention of engaging in business? One must have made a decision to start a business and have done something towards it. If still in set up stage, one might not have yet started the business. c) Does the owner have the motive of profit? d) Is there repetition and regularity of the activity in question? e) Is the activity similar to activities carried out by businesses in the same industry? f) The size, scale and permanency of the activity. g) Is the said activity planned, organized and carried on in business like manner?13 This can be established if; -The enterprise keeps records and books of accounts, -there is a separate bank account for the enterprise -there is a designated business premises -licenses/ qualifications -there is a registered business name for the enterprise. Advantages in terms of tax in being classified as a business: Being classified as a business for tax purposes has some advantages which include; -One is entitled to deduct expenses incurred in earning business income which is not the case for hobbies, -if the business activity results in a loss, one is entitled to offset the loss against other income or carry it forward and offset it against future profits14. The only disadvantage of being classified as a business for tax purposes is the fact that the income from the business activity will be assessable for tax purposes. Whether the division 35 provisions apply to negative gearing Division 35 provisions do not apply to negative gearing but it only applies to business losses. The provisions were inserted into ITAA 1997 by the new business tax system act 200015. The provisions deal with whether or not loss arising from a business activity can be offset against other income in the same year. Four tests in determining whether a deduction can be made include; -the assessable income from the business activity is at least $20000 -the business activity produces a profit in at least 3 of 5 years including the current year, The real property value used in carrying out the business is at least $500,000, -other assets used in carrying out the business are at least $100000. Read More