You and Your Money.
Are You Running a Business or a Hobby? Better Know the Rules!
by Michael Cook on 02/06/13
Hobby Losses (Business Re-Classified as a Hobby by the IRS) and the dangers of being audited?
Small-Businesses are always in danger of the IRS re-classifying their business activities as a Hobby. You need to know and understand the rules. My colleague and fellow Enrolled Agent (EA), Bonnie Lee, says it best.
“Activities not engaged in for Profit” or, in layman’s terms, hobbies, tend to be a red flag at the IRS.
Many taxpayers have hobbies that earn a bit of income and the IRS states that in such cases, expenses can be written off only to the extent of sales. A break-even proposition at best. So if you love photography and your buddy pays you $500 to shoot his wedding, you can write off all of your expenses up to $500 against that taxable income. But you cannot dip to the negative side and show a loss.
Many small business owners--particularly in this economic climate—are trying to shift their hobby into a bona fide business venture. And if it really is a business venture, then you are allowed to write off expenses in excess of sales and enjoy a loss against other income on your tax return thus reducing your tax liability. The trouble is, you’ve got to prove it.
So let’s say for the last three years you’ve been trying to make a go of your photography career. You’ve purchased state-of-the-art equipment and supplies, got a business license and worked to build a client base, but so far, you’ve only shown losses. And here comes the IRS looking to perform an audit of your business. But what’s in the back of the auditor’s mind is reclassifying your endeavor as a hobby. The losses will go away not just for the year under audit but for any other open years as well. And bam! You will owe the IRS a nice piece of change.
However, just because you are showing losses in a career that’s more fun than work, does not mean that your business is a hobby. The IRS must prove lack of business intent or have proof that the activity is not being treated as a business.
Prior to the audit, the examiner will look at your tax return. Here are some items that may indicate a hobby rather than business venture:
- Large expenses but very little in the way of sales reported on your Schedule C
- How the loss impacts the return – is it offsetting other income and substantially reducing your tax liability?
- Was there ever a profit?
- Is the activity fun? Boat chartering, fishing, gambling, writing, entertaining, farming, etc.
During the first phase of the audit, the examiner will pose various questions, and your answers could hint at a hobby rather than a business venture. Agents will want to speak to the taxpayer directly, but you have the right to representation and are not required to be present or answer any direct questions from an auditor.
Make sure your tax pro is informed of your daily business operations, the history of your business, how your books and records are maintained, your marketing strategies, your educational background and the content of your business plan. If the tax professional doesn’t have adequate knowledge in these areas, the auditor has the right to issue a summons to require the presence of the taxpayer. The examiner will also want to visit your business to get an overview of your operation.
An agent will also perform a “Tax Savings Benefit Analysis,” in which the reported income tax liability will be compared to what the liability would be without the business losses, and then check to see if the business appears to be on a trend toward profitability.
The IRS Audit Techniques manual lists nine factors the auditor will invoke to make the determination of “Whether or not an activity is presumed to be operated for profit requires an analysis of the facts and circumstances of each case. Deciding whether a taxpayer operates an activity with an actual and honest profit motive typically involves applying the nine non-exclusive factors contained in Treas. Reg. § 1.183-2(b). Those factors are:
- The manner in which the taxpayer carried on the activity,
- The expertise of the taxpayer or his or her advisers,
- The time and effort expended by the taxpayer in carrying on the activity,
- The expectation that the assets used in the 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 loss 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. “
These audits can be very tricky to handle and tax professionals can make the process more efficient and beneficial for small business owners. If you feel you can handle the audit yourself remember that if you don’t like the way things are going, or if you don’t understand something, you have the right to halt the audit and seek out help from a tax pro.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.”
Writing-Off Business Bad Debt?
by Michael Cook on 02/06/13
Writing-Off Business Bad Debt.
Business Clients are always asking me about writing-off bad debt. Everyone seems to have their own idea, but what are the rules. My colleague and fellow Enrolled Agent (EA), Bonnie Lee, says it best.
A client, let’s call her Amy, came into my office and told me her sad story about a sale she had made. She did the work but the client never paid and she wanted to know if she could write it off as a bad debt. I am asked this question on a regular basis. I explained to Amy that in a sense she had already written it off because instead of recording a sale, she’s recording a big zero, which is exactly what she got. You can’t reduce it twice.
If she had collected the money from the client, she would have a sale. She said, “But the job was worth $2800. Can’t I write off the value of that job - $2800 - as a loss?”
Here’s how the process works: First of all, in order to write off business bad debt you must make sure that you have a bona fide business operation. Check out this FOX Business article on Hobby Losses to make sure you qualify. You must then be on the accrual method of accounting.
Because Amy is on the cash basis of accounting, she cannot take the lack of sale and a $2,800 loss on top of it. It’s the same thing. Basically, you take the loss indirectly by not having a sale to report.
So in this example, if Amy were on the accrual basis, she would show $2,800 in income accrued and then write off $2,800 as bad debt. The net result is the same as it is for a cash basis taxpayer – zero.
Any incurred expenses relating to the sale are deductible. So in Amy’s situation, she had a consulting contract for $2,800. Amy paid her employee Susie $1300 to complete the contract and they racked up expenses for office supplies and software totaling $500. Those expenses are deductible, but the IRS does not allow you to deduct the loss of your profit. In this example, Amy shows zero in sales and $1,800 in costs for a loss of $1,800. The difference between the sale $2,800 and her costs of $1,800 is $1,000, which would have been taxable income had she collected from her client. As it stands, she will show a loss of $1,800 on this contract.
Amy understood the concept but was upset about the amount of time she had put into the project. “I spent an hour selling the concept, another hour talking to Susie about the scope of the job another hour reviewing the final product. That’s three hours I spent. My hourly rate is $125 so can’t I write off $375?”
Unfortunately, no.
In general, your time is worth nothing to the IRS. So when it comes to bad debt, you cannot assign a dollar value to your time and take it as a loss. This principal also holds true with donations of time. If you are a manicurist, donating your services to a women’s shelter does not qualify for a deduction, except for the cost of the supplies you use to perform the services, vehicle expense to take you from the salon to the shelter and back again and any other costs you may incur.
Bad debt could also be in the form of a bounced check. The customer has paid you, you’ve recorded the sale and the payment, but when the check bounces and is not redeemed by the customer, you may now take a deduction for bad debt. Note that this is a similar model to the accrual method; the sale is recorded and rather than payment, a bad debt is recorded against it resulting in zero.
Bad debt is deducted on Schedule C of your tax return if you are a sole proprietor or on your business tax return if your legal structure is corporate or partnership.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.”
New Proposed Regs.: Additional 0.9% Medicare Tax
by Michael Cook on 02/06/13
The New Additional (0.9%) Medicare Tax Proposed Regulations.
Starting in 2013, there is an additional 0.9% Medicare tax on the wages of employees and self-employed above $250,000 for married filing jointly, $125,000 for married filing separately, and $200,000 for everyone else. The additional Medicare tax is owed only by the employee; there is no employer portion of this tax.
An employer must withhold the added tax on all wages paid in excess of $200,000 in a calendar year, regardless of employee filing status. If the employee’s spouse work for the same employer and is paid over $200,000 in a calendar year, the employer must withhold the added tax on the spouse’s wages in excess of $200,000. However, if each earns, say $150,000, no added tax is withheld on either employee. If the added tax is not withheld, the employee must pay it in estimated taxes or when filing the 1040. If too much is withheld, the employee can claim a refund.
Please note, there may be underpayment penalties if the additional Medicare tax is paid with the 1040. Also, an employee cannot ask to have additional Medicare tax withheld above the required amount; only the FITW can be adjusted through the W-4.
Therefore, for those of you earning above $200,000 in 2013, and beyond, you should consult with your tax advisor and start planning for these changes.
Chaos Equals Poor Cash Flow
by Michael Cook on 01/13/13
Often business owners tell me that the chaos running rampant through their company is the result of poor cash flow. I frequently hear things like, “If only I had more money my company would run better.” However, I must respectfully disagree.
It is poor business processes that produce chaos. This chaos, in turn, leads to poor cash flow. Fix the poor business processes and the cash flow problems disappear.
I’m talking about business processes such as the following:
· Having a clear picture of who is your customer,
· Using this picture to develop services and/or products that provide value to your customer,
· Developing a plan of delivery.
Think through your business processes to see where there are holes. Otherwise, chaos will continue to swirl and cash flow will continue to suffer.
IRS Announded Delayed 2012 Tax E-Filing and Delayed Tax Refunds!!!
by Michael Cook on 01/11/13
Just a note for all you early Electronic Tax Filers, who can’t wait to get their 2012 Tax Refunds!
The IRS announced a delay to the start of e-filing of individual returns for Tax Year 2012. The 1040 e-filing was scheduled to begin Tuesday, January 22nd. The IRS announced the start of 1040 e-filing has been pushed back to Wednesday, January 30th.
The IRS cited the need to finalize forms and to complete programming and testing of its processing systems, after the passage of the American Taxpayer Relief Act (ATRA), as the reason for the delay.
The delay in the start of Individual Tax e-filing will impact those of you who receive tax refunds. The later start of the filing season means disbursement of funds will not begin until February. That is, no refunds will be received in January.
Additionally, the IRS also indicated that several forms impacted by ATRA will not be finalized or eligible to be filed until late February or early March. Some of the affected forms include Form 4562, Depreciation and Amortization, Form 3800, General Business Credits and Form 5695, Residential Energy Credits. And, the list goes on….
The IRS has also delayed e-filing of Tax Year 2012 Business Returns, including Forms 1120, 1120S and 1065. No start date has been announced. However, you can e-file the prior years (2011 and 2010) business returns.
I’ll keep you updated with the News as it affects You and Your Money!!! Stay tuned in! Facebook fans may keep tuned in on my Facebook (business) Page at http://www.facebook.com/YouAndYourMoney .
