Friday, September 25, 2009

Friday’s Tax Quote – September 25, 2009

Today’s quote comes from Bruce the Tax Guy over at the quality tax law blog

"We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle."

-Winston Churchill

Back in November 2008, Bruce compiled an anthology of tax quotes that you can read by clicking here.

Sunday, September 20, 2009

Hobby Losses: How Does the IRS Decide If Your Business Is a Hobby?

The determination as to whether an activity is a business or a hobby in the eyes of the IRS is ultimately based on the specific facts and circumstances. There is no simple definition to be applied to classify an activity as a hobby. Rather, the Internal Revenue Code and Treasury Regulations serve as guidelines for making the hobby vs. business determination.

Whether or not an activity is a business or hobby is ordinarily determined by analyzing 9 factors found in the Treasury Regulations. Knowing what these factors are in advance can help a business owner plan and take certain steps to overcome any hobby loss question that arises.

The factors are:

1. The manner in which the taxpayer carried on the activity.
2. The expertise of the taxpayer or his or her advisers.
3. The time and effort expended by the taxpayer in carrying on the activity.
4. The expectation that the assets used in the activity may appreciate in value.
5. The success of the taxpayer in carrying on other similar or dissimilar activities.
6. The taxpayer’s history of income or loss with respect to the activity.
7. The amount of occasional profits, if any, which are earned.
8. The financial status of the taxpayer.
9. Elements of personal pleasure or recreation.

It is important to mention that no single factor controls and that other factors may be considered. The mere fact that the number of factors indicating the lack of a profit objective exceeds the number indicating the presence of a profit objective (or vise versa) is not conclusive. That is, it is not a question of just adding up how many factors fall on the hobby or business side of the maths.

Unless the presumption discussed in my last hobby loss post applies, the taxpayer has the burden of proving that these factors establish the activity at issue is engaged in with an actual and honest objective of realizing a profit.

Hobby Losses: Safe Harbor Presumption.

When the IRS seeks to limit deductions for businesses reclassified as hobbies, it will look to nine factors listed in the Treasury Regulations. These factors are used to weigh the facts and circumstances that indicate a profit motive or lack thereof.

Before discussing the factors, it is important to note that the hobby loss rules are subject to a presumption that an activity is a business if certain requirements are met. If an activity turns a profit in 3 of 5 consecutive years, the activity is presumed to be a business. If so, the business is presumed to be allowed to deduct expenses beyond the amount of income from the activity and the losses can offset other income on a tax return. The calculation of the presumptions period begins with the first profitable year of the business.

When dealing with activities related to the breeding, training, showing or racing of horses, the presumption only requires a profit in 2 of 7 consecutive years.

It should be noted that meeting these requirements only creates a presumption. In an audit the IRS can work to rebut the presumption and may still be able to prove that the business should be classified as a hobby. In this analysis, the IRS will consider whether income and expenses have been manipulated to avoid application of the hobby loss rules. For example, the IRS is likely to raise the hobby issue in spite of the presumption if the activity shows only minor profits in 3 of 5 years but substantial losses in the other 2 years if those losses considerably outweigh the profits in the other 3 years.

Friday, September 18, 2009

Friday's Tax Quote - September 18, 2009

"The incidence of taxation depends upon the substance of a transaction."

- Hugo L. Black

Friday, September 4, 2009

Friday's Tax Quote - September 4, 2009

"Of course [the Orthodox Jewish dietary laws] are inconvenient at times, but not nearly as inconvenient as paying the federal income tax."

- Herman Wouk

Wednesday, September 2, 2009

Hobby Losses: What is the IRS Worried About?

Internal Revenue Code Section 183 limits the deductibility of expenses where the activity is determined to be a hobby instead of a business. These limitations prohibit a person from claiming losses from the hobby that exceeds the income from the activity. That is, a hobby cannot generate losses that offset other income on a tax return.

The reason that the hobby loss rules exist is to address the concern that taxpayers with substantial income from other sources will attempt to reduce their taxable income by engaging in an activity simply to generate losses that offset that income. For example, perhaps someone with substantial financial resources enjoys auto racing and spends a lot of money on the activity. The auto racing activity has no realistic possibility of turning a profit. That taxpayer might call the activity a business and attempt to reduce his substantial income (by claiming losses) and pay less tax.

The Treasury Inspector General for Tax Administration wrote in its 2007 report that approximately 1.5 million taxpayers filed a Schedule C with their tax returns showing only losses over the four year period 2002-2005. The report states that by claiming the losses, these taxpayers avoided paying roughly $28 billion in taxes in the year 2005 alone. This would seem to validate the IRS’ concern and likely explains the apparent increase in the number of hobby loss audits.

Unfortunately, in applying the hobby loss rules, some auditors seem to look past the basic reason for the hobby loss rules. By this I mean that the hobby loss rules are being applied against taxpayers without substantial income from other sources and to those that are not offsetting their taxable income by any meaningful amount. This means that even the proverbial “little guy” is getting caught up in hobby loss audits. Unfortunately, the way that the hobby loss rules are written allows this to happen. Later posts to this blog will discuss the hobby loss rules, an understanding of which can help a business owner dispute a hobby loss audit.

Tuesday, September 1, 2009

The Best Secret To Surviving an IRS Tax Audit

One shortcoming that most of my tax audit clients share is the failure to keep good records. I understand why, recordkeeping can be time consuming and running the day to day operations of a business takes priority. The problem is, if the IRS audits a person or business with bad records, it will likely result in a substantial tax liability because legitimate expenses cannot be proven. Because the burden of proving those expenses is on the business owners, no records = no expense deduction.

So, I preach good recordkeeping. It can be the difference between surviving an audit and going under because of the audit. The IRS agrees and has provided a brief discussion on recordkeeping and useful links on its website. Because the IRS is the group that will want to see your records, it makes sense to keep the kind of records that they will want to see. To learn more, I encourage you to check out the IRS news item "Keeping Good Records Reduces Stress at Tax Time."