The Accountant’s Daughter Says The IRS May See Your Business as a Hobby

When Husband began doing freelance design work we decided to give the business a more generalized name – X Consulting – so that if we decided to seek other business opportunities we could do it under the name of a single business.

Now that I’m going to be doing this new work I checked with my brother to see if it would be more advantageous tax-wise to have checks made payable to me or to X Consulting. He recommended I use X Consulting to further substantiate that it is, in fact, a business. He then shared with me this letter that my Dad’s office sends to clients about this very issue:

Like many of us, you’ve probably dreamed of turning a hobby or avocation into a regular business. You won’t have any unusual tax headaches if your new business is profitable. However, if the new enterprise consistently generates losses (deductions exceed income), the IRS may step in and say it’s a hobby-an activity not engaged in for profit-rather than a business. An activity is presumed to be engaged in for profit for a tax year if it shows a profit for any three or more out of five consecutive years ending in that tax year. Otherwise, it can be deemed a hobby.

What are the practical consequences? Under the so-called hobby loss rules, you’ll be able to claim those deductions that are available whether or not the enterprise is engaged in for profit (such as state and local property taxes). However, your deductions for business-type expenses (such as rent or advertising) will be limited to the excess of your gross income from the hobby over those expenses that are deductible whether or not the enterprise is engaged in for profit. Deductible hobby expenses are claimed on Schedule A of Form 1040 as miscellaneous itemized deductions subject to a 2%-of-AGI “floor.” By contrast, if the new enterprise isn’t affected by the hobby loss rules, all otherwise allowable expenses would be deductible on Schedule C, even if they exceeded income from the enterprise.

There are two ways to avoid the hobby loss rules. The first way is to show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing, or racing horses). The second way is to run the venture in such a way as to show that you intend to turn it into a profit-maker, rather than operate it as a mere hobby. The IRS regs themselves say that the hobby loss rules won’t apply if the facts and circumstances show that you have a profit-making objective.

How can you prove that you have a profit-making objective? In general, you can do so by running the new venture in a businesslike manner. More specifically, IRS and the courts will look to the following factors: how you run the activity; your expertise in the area (and your advisers’ expertise); the time and effort you expend in the enterprise; whether there’s an expectation that the assets used in the activity will rise in value; your success in carrying on other similar or dissimilar activities; your history of income or loss in the activity; the amount of occasional profits (if any) that are earned; your financial status; and whether the activity involves elements of personal pleasure or recreation.

The classic “hobby loss” situation involves a successful businessperson or professional who starts something like a dog-breeding business, or a farm. But IRS’s long arm also can reach out to more prosaic situations, such as businesspeople who start what appears to be a bona-fide sideline business.

Please call our offices to get more details on whether a venture of yours may be affected by the hobby loss rules, and what you should do right now to avoid a tax challenge.

So, there you are. Something to think about courtesy of The Accountant’s Daughter.

~

As always, please remember that I am not an expert on finance, or an accountant. I’m just an accountant’s daughter. So, please, please, please contact your accountant for expert advice.

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Saving and Spending and Everyone Wins

My husband is a production director/art director/graphic designer. He has a full-time position and does occasional freelance jobs on the side. We live fairly frugally well on his salary, but those freelance jobs allow us to have some extras, take frugal vacations and let us do some saving. Living on his income alone just doesn’t leave room for too many extravagances, or for saving. I love that we have that source of potential income – there certainly weren’t any freelance opportunities for me when I was an insurance agent.

The freelancing made our purchase of his new computer possible, and sensible. The original plan was to have him earn the money ($4000!) freelancing before the purchase. He’d earned nearly half when I decided to take money out of savings and get it for him for Christmas. He still needed to find the freelance jobs to pay back savings, but at least he’d have the machine in the meantime. Besides, he works hard for us. He deserved it.

I suspected that once he had the computer that his previously dogged search for new clients would falter, and I was right. The only dent he’s made since Christmas in the outstanding balance that he “owes” savings is the $200 credit we got from Apple after he called to complain about the better (and less expensive) system they released just a few weeks after I bought his. I’ve not been upset about his lack of motivation, but I’ve noticed it.

I started bringing in a few jobs myself. A few weeks ago I reconnected with an old friend, and he’s asked us to do his website. Another ex-client of mine called this week looking for a logo for a new company she’s forming. It doesn’t matter who brings in the business, as long as it gets brung. Neither are huge jobs, but they will chip away at that total all the same.

Then, yesterday, it looks like he landed a very lucrative video contract. This would pay off more than twice the balance, plus it has the potential to become a semi-regular gig. This is great news for us, if it pans out. Still, I’m not counting my chickens before they’re hatched.

Tonight we were discussing the possible new job, and we had a little disagreement about what to do with the extra money. He wants to spend it. He works hard for us, and he really doesn’t ask for a lot (but he always gets it, even if he has to wait a bit). Also, he never asks me for an accounting of what I spend money on (though he does get the highlights, and we always discuss any purchase over $100).

I want to save it. Even though we have no debt besides our mortgage, we had a few big expenses late last year that chipped away some of our savings. Additionally, we’re looking to move, and I’d like to be able to pay cash for our next car the way we did with our last two.

We decided that we’re both right. So, he’ll take some of the money to do whatever he wants with (please, no Slurpee machine!), and the rest would go into savings.

Even though I’d rather put it all in savings, I understand that it’s important for him to see some fruit for his labors. Even though he’d like to go on a man-toy shopping spree, he understands that it’s important for me to feel secure in our financial future. We found a way for us both to win.

Hot dog!

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