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Tax and Financial News for September 2012

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Business or Hobby? It Matters to the IRS

Are you running a business or is it a hobby? Although in reality the lines may blur, it makes a big difference on your taxes.

According to the IRS, the incorrect deduction of hobby expenses accounts for a portion of $30 billion per year in unpaid taxes and is a frequent issue in IRS audits.

The IRS defines a hobby as an activity that is not engaged in with the expectation of making a profit, while a business is an activity carried out with a reasonable expectation of making one. When engaged in a hobby, a taxpayer can only deduct expenses up to the amount of income made from the hobby; and even then, hobby and other miscellaneous expenses itemized on Schedule A must add up to more than 2 percent of the taxpayer’s adjusted gross income before they are deductible.

On the other hand, a taxpayer can generally deduct all the ordinary and necessary expenses for conducting a trade or business. Taxpayers run into trouble when they deduct these business expenses and then discover that the IRS believes they are actually engaged in a hobby.

The IRS has two tests to determine whether an activity is a business or a hobby. First, it is presumed that an activity is being carried out for profit if the activity actually makes a profit during at least three of the last five years, including the current year.

If a taxpayer fails the profit test, then the IRS uses a facts and circumstances test to determine whether an activity constitutes a business. This test weighs several different factors that necessarily involve the judgment of IRS employees, but which can also suggest potential arguments a taxpayer might use when appealing the findings of an audit.

First, the IRS will try to determine whether the activity is carried out in a businesslike manner by looking at how records are kept, whether the taxpayer promotes the business, and if he or she tries to hold down costs as much as possible. Is there a business plan or an outline of when the taxpayer reasonably expects to make a profit? Is there a separate business bank account?

Second, does the time and effort put into the activity indicate the intention to make a profit? The IRS will try to determine whether the taxpayer depends on the income from the activity.

Third, if there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the startup phase of the business? The IRS recognizes that many businesses do not expect to make a profit early in their life cycle, but they will want to see if the taxpayer has changed any methods of operation to improve profitability.

Fourth, the IRS will look at the taxpayer’s past. Has he or she made a profit from similar activities in the past? Does he or she have prior business experience? Does the taxpayer have the knowledge needed to carry on the activity as a successful business?

Finally, the IRS will look at whether the activity has made a profit in past years and whether there is a reasonable expectation of future profit from the appreciation of assets used in the activity.

Taxpayers often find themselves caught between a rock and a hard place in determining whether an activity is a business or a hobby. If you call it a business but don’t make a profit, you can’t deduct your business expenses. But if you call it a hobby and make money, then you owe taxes. Tax professionals can provide invaluable advice to help create the records necessary to support an argument that an activity constitutes a business, and they know the intricacies of IRS regulations so they can effectively represent you in an audit.

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