Author: Leon Clinton

Business Tax

Hobby or Business? Why It Matters

Millions of Americans have hobbies such as sewing, woodworking, fishing, gardening, stamp and coin collecting, but when that hobby starts to turn a profit, it might just be considered a business by the IRS.

Definition of a Hobby vs a Business

The IRS defines a hobby as an activity that is not pursued for profit. A business, on the other hand, is an activity that is carried out with the reasonable expectation of earning a profit.

The tax considerations are different for each activity so it’s important for taxpayers to determine whether an activity is engaged in for profit as a business or is just a hobby for personal enjoyment.

Of course, you must report and pay tax on income from almost all sources, including hobbies. But when it comes to deductions such as expenses and losses, the two activities differ in their tax implications.

Is Your Hobby Actually a Business?

If you’re not sure whether you’re running a business or simply enjoying a hobby, here are some of the factors you should consider:

  • Does the time and effort 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 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?
  • Do you expect to make a profit in the future from the appreciation of assets used in the activity?

An activity is presumed to be for profit if it makes a profit in at least three of the last five tax years, including the current year (or at least two of the last seven years for activities that consist primarily of breeding, showing, training, or racing horses).

The IRS says that it looks at all facts when determining whether a hobby is for pleasure or business, but the profit test is the primary one. If the activity earned income in three out of the last five years, it is for profit. If the activity does not meet the profit test, the IRS will take an individualized look at the facts of your activity using the list of questions above to determine whether it’s a business or a hobby. (It should be noted that this list is not all-inclusive.)

Business Activity: If the activity is determined to be a business, you can deduct ordinary and necessary expenses for the operation of the business on a Schedule C or C-EZ on your Form 1040 without considerations for percentage limitations. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is appropriate for your business.

Hobby: If an activity is a hobby, not for profit, losses from that activity may not be used to offset other income. You can only deduct expenses up to the amount of income earned from the hobby. These expenses, with other miscellaneous expenses, are itemized on Schedule A and must also meet the 2 percent limitation of your adjusted gross income in order to be deducted.

What Are Allowable Hobby Deductions?

If your activity is not carried on for profit, allowable deductions cannot exceed the gross receipts for the activity.

Note: Internal Revenue Code Section 183 (Activities Not Engaged in for Profit) limits deductions that can be claimed when an activity is not engaged in for profit. IRC 183 is sometimes referred to as the “hobby loss rule.”

Deductions for hobby activities are claimed as itemized deductions on Schedule A, Form 1040. These deductions must be taken in the following order and only to the extent stated in each of three categories:

  • Deductions that a taxpayer may claim for certain personal expenses, such as home mortgage interest and taxes, may be taken in full.
  • Deductions that don’t result in an adjustment to the basis of property, such as advertising, insurance premiums, and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
  • Deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.

If your hobby is regularly generating income, it could make tax sense for you to consider it a business because you might be able to lower your taxes and take certain deductions.

Still wondering whether your hobby is actually a business? Give us a call, we’ll help you figure it out.

Asset Protection Estate Financial Planning

Living Trusts 101

A trust, like a corporation, is an entity that exists only on paper but is legally capable of owning property. However, a live person called the trustee must be in charge of the property. Further, you can actually be the trustee of your own living trust, keeping full control over all property legally owned by the trust.

Note: Property held in trust is actually “owned” by the trustees of the trust, subject to the rights of the beneficiaries. The trust itself doesn’t actually own anything.

There are many kinds of trusts. A living trust (also called an inter vivos trust) is simply a trust you create while you’re alive, rather than one that is created upon your death under the terms of your will.

All living trusts are designed to avoid probate. Some also help you save on estate taxes, while others let you set up long-term property management.

Do I need a living trust?
Property you transfer into a living trust before your death doesn’t go through probate. The successor trustee, the person you appointed to handle the trust after your death, simply transfers ownership to the beneficiaries you named in the trust.

In many cases, the whole process takes only a few weeks and there are no attorney or court fees to pay. When the property has all been transferred to the beneficiaries, the living trust ceases to exist.

Is it expensive to create a living trust?
The cost of creating a living trust depends on what you want to achieve. The more complicated a living trust is, the more expensive it will be. Also important to note is that while the fees associated with creating a living will are paid upfront a living trust actually saves you money and time by avoiding probate court.

Is a trust document ever made public, like a will?
A will becomes a matter of public record when it is submitted to a probate court, as do all the other documents associated with probate – inventories of the deceased person’s assets and debts, for example. The terms of a living trust, however, need not be made public.

Does a trust protect property from creditors?
Holding assets in a revocable trust does not shelter those assets from creditors. A creditor who wins a lawsuit against you can go after the trust property just as if you still owned it in your own name.

After your death, however, property in a living trust can be quickly and quietly distributed to the beneficiaries (unlike property that must go through probate). That complicates matters for creditors; by the time they find out about your death, your property may already be dispersed, and the creditors have no way of knowing exactly what you owned (except for real estate, which is always a matter of public record). It may not be worth the creditor’s time and effort to try to track down the property and demand that the new owners use it to pay your debts.

On the other hand, probate can offer a kind of protection from creditors. During probate, known creditors must be notified of the death and given a chance to file claims. If they miss the deadline to file, they’re out of luck forever.

Do I need a trust if I’m young and healthy?
Probably not. At this stage in your life, your main estate planning goals are probably making sure that in the unlikely event of your premature death, your property is distributed how you want it to be and, if you have young children, that they are cared for. You don’t need a trust to accomplish those ends; writing a will, and perhaps buying some life insurance is sufficient.

Can a living trust save taxes?
A simple probate-avoidance living trust has no effect on either income or estate taxes. More complicated living trusts, however, can greatly reduce your federal estate tax bill if you expect your estate to owe estate tax at your death.

If you’re wondering whether you need a living trust give us a call. We’ll help you figure out the answer.

Business Tax

Lending Money to Family? Make it a Tax-Smart Loan

Lending money to a cash-strapped family member or friend is a noble and generous offer that just might make a difference. But before you hand over the cash, you need to plan ahead to avoid tax complications down the road.

Let’s say you decide to loan $5,000 to your daughter who’s been out of work for over a year and is having difficulty keeping up with the mortgage payments on her condo. While you may be tempted to charge an interest rate of zero percent, you should resist the temptation. Here’s why.

When you make an interest-free loan to someone, you will be subject to “below market interest rules”. IRS rules state that you need to calculate imaginary interest payments from the borrower. These imaginary interest payments are then payable to you and you will need to pay taxes on these interest payments when you file a tax return. Further, if the imaginary interest payments exceed $13,000 for the year, there may be adverse gift and estate tax consequences.

Exception: The IRS lets you ignore the rules for small loans ($10,000 or less), as long as the aggregate loan amounts to a single borrower are less than $10,000 and the borrower doesn’t use the loan proceeds to buy or carry income-producing assets.

In addition, if you don’t charge any interest, or charge interest that is below market rate (more on this below), then the IRS might consider your loan a gift, especially if there is no formal documentation (i.e. written agreement with payment schedule) and you go to make a nonbusiness bad debt deduction if the borrower defaults on the loan–or the IRS decides to audit you and decides your loan is really a gift.

Formal documentation generally refers to a written promissory note that includes the interest rate, a repayment schedule showing dates and amounts for all principal and interest, and security or collateral for the loan, such as a residence (see below). Make sure that all parties sign the note so that it’s legally binding.

As long as you charge an interest rate that is at least equal to the applicable federal rate (AFR) approved by the Internal Revenue Service, you can avoid tax complications and unfavorable tax consequences.

AFRs for term loans, that is, loans with a defined repayment schedule, are updated monthly by the IRS and published in the IRS Bulletin. AFRs are based on the bond market, which change frequently. For term loans, use the AFR published in the same month that you make the loan. The AFR is a fixed rate for the duration of the loan.

Any interest income that you make from the term loan is included on your Form 1040. In general, the borrower, in this case your daughter cannot deduct interest paid, but there is one exception: if the loan is secured by her home, then the interest can be deducted as qualified residence interest–as long as the promissory note for the loan was secured by the residence.

If you have questions about the tax implications of loaning a family member money, don’t hesitate to call us. We’re here to help.

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