Tag Archive for Business Expense
The two major start up business expenses are the costs to organize and the costs of normal business expenses incurred prior to the beginning of business or the point where the business is ready to receive revenue. Sole proprietors do not normally have costs to organize because a business entity is not formed however they could expend substantial up-front business expenses. Under the Small Business Jobs Act of 2010, the amount a taxpayer can deduct for start up expenditures is increased from $5,000 to $10,000 [IRC Sec. 195(b)(3)].
Additionally starting in 2010 the phaseout threshold is increased from $50,000 to $60,000. Amounts in excess of $10,000, but less than $60,000, are amortized over fifteen years. What this means in plain terms is that the $10,000 (previously $5,000) deduction for start up expenses is now reduced (but not below zero) by the amount of cumulative start-up expenditures that exceed $60,000 (previously $50,000).
Start-up expenses have always been an item IRS examiners address in an audit of a new Schedule C business. I often get asked in examination if the sole proprietor deduct all costs from the first “idea” day until the first “business” day. It is important to have supporting documentation supporting both dates.
Start-up expenses could include advertising; salaries and wages paid to employees who are being trained and their instructors; travel and other expenses incurred in lining up prospective
distributors, supplies, or customers; salaries or fees paid or incurred for executives, consultants, as well as similar professional services, interest (Sec. 163), taxes (Sec. 164) and research and experimental expenses (Sec. 174).
If you think you have a viable ongoing business with a profit motive be sure to maintain adequate financial records on a computer that you back up off site on a regular and consistent basis. Also be aware that in the tax court case of Chandler v. Commissioner (TC Memo 2010-92) the significance of inadequate hand kept records was a major determining factor in ruling that the tax payer’s horse breeding business was actually a hobby and not a business.
Even though the tax code states that handwritten records are an acceptable method for maintaining the accounting books as long as the records are accurate and provide substantial information for the taxpayer to prepare the tax return [Reg. §1.446-1(a)(4)], the tax court’s determination as drafted in TC Memo 2010-92 compels me to ALWAYS recommend the use of bookkeeping software.
In this case the IRS issued a deﬁciency notice citing lack of proﬁt motive under §183 for horse breeding, training and racing activities. The IRS also determined Jo Anne, the tax payer, was liable for a §6662(a) accuracy related penalty in regard to maintaining adequate books and records for her horse breeding and training business.
The Tax Court determined the handwritten records Jo Anne kept
did not prove to be accurate or substantial. The Court also found
Jo Anne was able to reduce taxable income by approximately 40 percent for the years in question by claiming losses on her Schedule F relating to the horse breeding and training activities. Because the taxpayer did not provide the Court with adequate records and was unable to prove she was engaged in these activities for a proﬁt otherwise, the dis-allowance of the deductions under §183(a) increased Jo Anne’s tax liability and she was held liable for the tax along with interest and penalties for the years under review.
Only by considering all the facts and circumstances of each situation can you determine whether an expense was incurred in a “trade or business,”and whether it was an “ordinary and necessary” expense for that business, making it a deductible expense.
Before you can determine whether expenses may be deducted, to what extent they can be deducted, and how to report them on your tax return, you will first need to determine whether the activity is a business or a hobby. For tax purposes, a hobby is an as activity that is “not engaged in for profit.”
After you determine that the activity is a business or a hobby, you will be better prepared to evaluate the deductibility of expenses and where to report them. The implications of this decision can be significant. In general, if you determine that an activity is a hobby (i.e., not engage in for profit) expenses are restricted in at least four ways:
They are limited to hobby income. According to IRC Sec. 183(b)(2), deductions that are allowable may be deducted “to the extent that the gross income derived from such activity for the taxableyear exceeds the deductions allowable…” In other words, a loss from hobby income cannot be used to offset ordinary income.
Hobby expenses are reported as itemized deductions on Schedule A. Unlike a deduction that qualifies as a business expense, hobby expenses are deductions from Adjusted Gross Income (AGI), rather than for AGI (as they would be as business deductions on Schedule C). Thus, not only is AGI increased by hobby income, but AGI cannot be reduced dollar-for-dollar by hobby expenses. Moreover, the hobby income may increase AGI to a level that disqualifies from claiming certain tax benefits, or reduces such benefits due to phaseouts.
The hobby expenses reported onSchedule A, but they are considered miscellaneous itemized deductions subject to the2%-of-AGI limit (which, of course, is nowhigher because of his hobby income). As if this were not enough, miscellaneous itemized deductions are preference items for the alternative minimum tax (AMT). Therefore, if hobby expenses are high enough, the miscellaneous deduction could trigger (or increase) AMT income (AMTI).
Unlike suspended losses for passive activity income, hobby losses may not be carried forward to a year in which hobby income is high enough to absorb such losses. Any unused expenses for the year are permanently lost.
If you determine that an activity is a hobby, you will report income on Form 1040 line 21, rather than on Schedule C. The silver lining here is that such income is not subject to self-employment tax.
Classifying activity as a business offers distinct advantages by allowing deductions to offset related income, possibly generate a net operating loss, and reduce AGI (and possibly AMTI). Due diligence in this matter involves asking relevant questions, documenting, and clarifying inconsistencies and other facts. There is no “hobby loss” due diligence. Fortunately, the regulations do offer guidance in determining whether an activity is a business or a hobby. Reg. Sec. 1.183-2(b) offers nine factors, including examples used to make such a determination.
It is important to note that these factors do not constitute an exhaustive checklist. Satisfying five out of nine factors does not automatically allow the taxpayer to “pass the test” of whether the activity is a for-profit business. Moreover, none of the factors dominate; there is no litmus test that automatically qualifies an activity as a business or a hobby. The regulation states, “The determination whether an activity is engaged in for profit is to be made by reference to objective standards, taking into account all of the facts and circumstances of each case.” The nine factors of Reg. Sec. 1.183-2(b)(1)–(9) are:
The manner in which the taxpayer carries on the activity. The fact that the taxpayer carries on the activity in a businesslike manner and maintains complete and accurate books and records may indicate that the activity is engaged in for profit. Similarly, where an activity is carried on in a manner substantially similar to other activities of the same nature which are profitable, a profit motive may be indicated. A change of operating methods, adoption of new techniques, or abandonment of unprofitable methods in a manner consistent with an intent to improve profitability may also indicate a profit motive.
The expertise of the taxpayer or his/her advisors. Preparation for the activity by extensive study of its accepted business, economic, and scientific practices, or consultation with those who are expert therein, may indicate that the taxpayer has a profit motive where the taxpayer carries on the activity in accordance with such practices. Where a taxpayer has such preparation or procures such expert advice, but does not carry on the activity in accordance with such practices, a lack of intent to derive profit may be indicated unless it appears that the taxpayer is attempting to develop new or superior techniques which may result in profits from the activity.
The time and effort expended by the taxpayer in carrying on the activity. The fact that the taxpayer devotes much of his personal time and effort to carrying on an activity, particularly if the activity does not have substantial personal or recreational aspects, may indicate an intention to derive a profit. A taxpayer’s withdrawal from another occupation to devote most of his energies to the activity may also be evidence that the activity is engaged in for profit. The fact that the taxpayer devotes a limited amount of time to an activity does not necessarily indicate a lack of profit motive where the taxpayer employs competent and qualified persons to carry on such activity.
Expectation that assets used in activity may appreciate in value. The term “profit” encompasses appreciation in the value of assets, such as land, used in the activity. Thus, the taxpayer may intend to derive a profit from the operation of the activity, and may also intend that, even if no profit from current operations is derived, an overall profit will result when appreciation in the value of land used in the activity is realized since income from the activity together with the appreciation of land will exceed expenses of operation.
The success of the taxpayer in carrying on other similar or dissimilar activities. The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he is engaged in the present activity for profit, even though the activity is presently unprofitable.
The taxpayer’s history of income or losses with respect to the activity. A series of losses during the initial or start-up stage of an activity may not necessarily be an indication that the activity is not engaged in for profit. However, where losses continue to be sustained beyond the period which customarily is necessary to bring the operation to profitable status, such continued losses, if not explainable, as due to customary business risks or reverses, may be indicative that the activity is not being engaged in for profit. If losses are sustained because of unforeseen or fortuitous circumstances which are beyond the control of the taxpayer, such as drought, disease, fire, theft, weather damages, other involuntary conversions, or depressed market conditions, such losses would not be an indication that the activity is not engaged in for profit. A series of years in which net income was realized would of course be strong evidence that the activity is engaged in for profit.
The amount of occasional profits, if any, which are earned. The amount of profits in relation to the amount of losses incurred, and in relation to the amount of the taxpayer’s investment and the value of the assets used in the activity, may provide useful criteria in determining the taxpayer’s intent. An occasional small profit from an activity generating large losses, or from an activity in which the taxpayer has made a large investment, would not generally be determinative that the activity is engaged in for profit. However, substantial profit, though only occasional, would generally be indicative that an activity is engaged in for profit, where the investment or losses are comparatively small. Moreover, an opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit even though losses or only occasional small profits are actually generated. The IRS allows a “presumption for profit” in activities that are occasionally profitable. Needless to say, not every business earns a profit every year, made even more difficult by these economic times. Thus, the lack of profit does not nullify a taxpayer’s intent to create a profit. In general, IRS grants that a taxpayer who has earned a profit in an activity for at least three of the previous five years is presumed to have a profit motive.
The financial status of the taxpayer. The fact that the taxpayer does not have substantial income or capital from sources other than the activity may indicate an activity is engaged in for profit. Substantial income from sources other than the activity (particularly if the losses from the activity generate substantial tax benefits) may indicate the activity is not engaged in for profit especially if there are personal or recreational elements involved. As the regulation suggests, if the activity is the taxpayer’s only source of income, there is greater probability the taxpayer has a profit motive in undertaking the activity.
Elements of personal pleasure or recreation. The presence of personal motives in carrying on of an activity may indicate the activity is not engaged in for profit, especially where there are recreational or personal elements involved. On the other hand, a profit motivation may be indicated where an activity lacks any appeal other than profit. It is not, however, necessary that an activity be engaged in with the exclusive intention of deriving a profit or with the intention of maximizing profits. For example, the availability of other investments which would yield a higher return, or which would be more likely to be profitable, is not evidence that an activity is not engaged in for profit. An activity will not be treated as not engaged in for profit merely because the taxpayer has purposes or motivations other than solely to make a profit. Also, the fact that the taxpayer derives personal pleasure from engaging in the activity is not sufficient to cause the activity to be classified as not engaged in for profit if the activity is in fact engaged in for profit as evidenced by other factors. The concept of mixing business with pleasure suggests they are separate and implies that a business activity is distinct from a pleasurable activity. That said, the element of pleasure in an activity, as the reg. notes, may indicate the activity is not engaged in for profit. Taxpayers who breed and race horses, or buy and race fast cars, or carry on other expensive activities may try to “write off” their hobbies, and you must pay careful attention to such situations.
Rowing, X-C skiing, Biking, Running, Mountain Climbing, Guitar Playing, Fishing, Gardening, Golf, Sewing, Woodworking, Horsemanship, Scrap Booking, Stamp and Coin Collecting, etc.
The IRS isn’t trying to spoil your fun but if your favorite activity makes a profit every year or so, there may be tax implications that surprise you.
What is a hobby? Hobbies, also called not-for-profit activities, are those activities that are not pursued for profit.
What is a business? Generally, your activity is considered a business if it is carried on with the reasonable expectation of earning a profit.
If you are not sure whether you are running a business or simply enjoying a hobby, here are some of the factors you should consider:
Do you run the activity in a businesslike manner?
Does the time and effort you put into the activity indicate an intention to make a profit?
Do you depend on income from the activity?
If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
Have you changed methods of operation to improve profitability?
Do you or your advisors have the knowledge needed to carry on the activity as a successful business?
Have you made a profit in similar activities in the past?
Does the activity make a profit in some years?
Can you expect to make a profit in the future from the appreciation of assets used in the activity?
An activity is usually considered a business if it makes a profit during at least three of the last five tax years, including the current year.
An exception is breeding, showing, training or racing horses. Such activity is presumed to be a business if it makes a profit during at least two of the last seven years.
If you are conducting a trade or business you may deduct your ordinary and necessary expenses. An ordinary expense is an expense that is common and accepted in your trade or business. A necessary expense is one that is appropriate for your business.
Losses from a not-for-profit activity (hobby) may not be used to offset other income.
It is possible to claim some deductions for hobby activities as itemized deductions on your Form 1040 income tax return. However, there are special rules and limits to the deductions you can claim, and those deductions may not exceed the gross income from your hobby.