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Want to turn a hobby into a business? Watch out for the tax rules

Like many people, you may have dreamed of turning a hobby into a regular business. You won’t have any tax headaches if your new business is profitable. But what if the new enterprise consistently generates losses (your deductions exceed income) and you claim them on your tax return? You can generally deduct losses for expenses incurred in a bona fide business. However, the IRS may step in and say the venture is a hobby — an activity not engaged in for profit — rather than a business. Then you’ll be unable to deduct losses. By contrast, if the new enterprise isn’t affected by the hobby loss rules because it’s profitable, all otherwise allowable expenses are deductible on Schedule C, even if they exceed income from the enterprise.

Note: Before 2018, deductible hobby expenses had to be claimed as miscellaneous itemized deductions subject to a 2%-of-AGI “floor.” However, because miscellaneous deductions aren’t allowed from 2018 through 2025, deductible hobby expenses are effectively wiped out from 2018 through 2025.

Avoiding a hobby designation

There are two ways to avoid the hobby loss rules: Show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing or racing horses). 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 you have a profit-making objective?

You should run the venture in a businesslike manner. The IRS and the courts will look at the following factors: How you run the activity, Your expertise in the area (and your advisors’ 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 activities, Your history of income or loss in the activity, The amount of any occasional profits earned, Your financial status, and Whether the activity involves elements of personal pleasure or recreation.

Recent court case

In one U.S. Tax Court case, a married couple’s miniature donkey breeding activity was found to be conducted with a profit motive. The IRS had earlier determined it was a hobby and the couple was liable for taxes and penalties for the two tax years in which they claimed losses of more than $130,000. However, the court found the couple had a business plan, kept separate records and conducted the activity in a businesslike manner. The court stated they were “engaged in the breeding activity with an actual and honest objective of making a profit.” (TC Memo 2021-140)

Visit our small and emerging business page to learn more or contact one of our experts to discuss details on whether a venture of yours may be affected by the hobby loss rules, and what you should do to avoid a tax challenge. © 2022

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General

Can you deduct the costs of a spouse on a business trip?

If you own your own company and travel for business, you may wonder whether you can deduct the costs of having your spouse accompany you on trips. The rules for deducting a spouse’s travel costs are very restrictive. First of all, to qualify, your spouse must be your employee. This means you can’t deduct the travel costs of a spouse, even if his or her presence has a bona fide business purpose, unless the spouse is a bona fide employee of your business. This requirement prevents tax deductibility in most cases.

A spouse-employee

If your spouse is your employee, then you can deduct his or her travel costs if his or her presence on the trip serves a bona fide business purpose. Merely having your spouse perform some incidental business service, such as typing up notes from a meeting, isn’t enough to establish a business purpose. In general, it isn’t sufficient for his or her presence to be “helpful” to your business pursuits — it must be necessary. In most cases, a spouse’s participation in social functions, for example as a host or hostess, isn’t enough to establish a business purpose. That is, if his or her purpose is to establish general goodwill for customers or associates, this is usually insufficient.

Further, if there’s a vacation element to the trip (for example, if your spouse spends time sightseeing), it will be more difficult to establish a business purpose for his or her presence on the trip. On the other hand, a bona fide business purpose exists if your spouse’s presence is necessary to care for a serious medical condition that you have. If your spouse’s travel satisfies these tests, the normal deductions for business travel away from home can be claimed. These include the costs of transportation, meals, lodging, and incidental costs such as dry cleaning, phone calls, etc.

A non-employee spouse

Even if your spouse’s travel doesn’t satisfy the requirements, however, you may still be able to deduct a substantial portion of the trip’s costs. This is because the rules don’t require you to allocate 50% of your travel costs to your spouse. You need only allocate any additional costs you incur for him or her. For example, in many hotels the cost of a single room isn’t that much lower than the cost of a double. If a single would cost you $150 a night and a double would cost you and your spouse $200, the disallowed portion of the cost allocable to your spouse would only be $50.

In other words, you can write off the cost of what you would have paid traveling alone. To prove your deduction, ask the hotel for a room rate schedule showing single rates for the days you’re staying. And if you drive your own car or rent one, the whole cost will be fully deductible even if your spouse is along. Of course, if public transportation is used, and for meals, any separate costs incurred by your spouse wouldn’t be deductible.

Contact us if you have questions about this or other tax-related topics. © 2022

Categories
Tax

What Can Be Written Off as a Business Expense? 

Watch the tax planning video on small business expenses here.

Your business expenses can translate into tax write-offs, also known as deductions, as long as they’re “ordinary and necessary“—that is, common in your industry and essential to your business. When an expense meets those requirements for your business, you can deduct it.

Some of these include:

  • Internet Expenses
  • Office space 
  • And payment to employees

We hear many business owners wanting clarification on office space, including home offices, as well as business meal expenses.

Overlapping company and personal expenses 

Sometimes an expense can be broken down between your business and your personal life. For example, if you use part of your home as your office and use that area solely for business purposes, then you can make a home office deduction. The standard method of deducting home office expenses involves calculating the percentage of your home that is used for business by taking the square footage of your office area and dividing it by the total square footage of  your home.

Let’s say your office is 5% of your home’s square footage, so you can deduct 5% of the cost of your mortgage interest, utilities, insurance and other related expenses at tax time.

You can apply a similar model to the times you use your personal vehicle for business, by keeping track of miles driven and deducting based on the IRS’s standard mileage rate.  

Common Non-Deductible Business Expenses

Some costs related to doing business cannot be deducted from your taxable income. Common examples include lobbying or political costs and penalties/fines. Additionally, entertainment costs such as tickets to a sporting event cannot be expensed. Prior to this year, only 50% of business meals were deductible. As part of the Consolidated Appropriations Act (2021), the deductibility of business meals is changing. Food and beverages will be 100% deductible if purchased from a restaurant in 2021 and 2022. This temporary 100% deduction was designed to help restaurants, many of which have been hard-hit by the COVID-19 pandemic.

The first thing you should do to help keep track of your small business expenses is to open separate business checking and savings accounts for your business. After that, ensure that you’re also keeping your business expenses separate from your personal expenses.

Small businesses contribute to local economies by bringing growth and innovation to the community. ATA walks alongside business owners to help overcome challenges in an efficient and experienced manner. To discuss business expenses in depth, contact one of our experts for a consultation.  

Categories
Tax

Getting a new business off the ground: How start-up expenses are handled on your tax return

Despite the COVID-19 pandemic, government officials are seeing a large increase in the number of new businesses being launched. From June 2020 through June 2021, the U.S. Census Bureau reports that business applications are up 18.6%. The Bureau measures this by the number of businesses applying for an Employer Identification Number. Entrepreneurs often don’t know that many of the expenses incurred by start-ups can’t be currently deducted. You should be aware that the way you handle some of your initial expenses can make a large difference in your federal tax bill.

How to treat expenses for tax purposes
If you’re starting or planning to launch a new business, keep these rules in mind:

Start-up costs include those incurred or paid while creating an active trade or business — or investigating the creation or acquisition of one. Under the tax code, taxpayers can elect to deduct up to $5,000 of business start-up and $5,000 of organizational costs in the year the business begins. As you know, $5,000 doesn’t go very far these days! And the $5,000 deduction is reduced dollar-for-dollar by the amount by which your total start-up or organizational costs exceed $50,000.

Any remaining costs must be amortized over 180 months on a straight-line basis. No deductions or amortization deductions are allowed until the year when “active conduct” of your new business begins. Generally, that means the year when the business has all the pieces in place to start earning revenue. To determine if a taxpayer meets this test, the IRS and courts generally ask questions such as: Did the taxpayer undertake the activity intending to earn a profit? Was the taxpayer regularly and actively involved? Did the activity actually begin?

Eligible expenses
In general, start-up expenses are those you make to: investigate the creation or acquisition of a business, create a business, or engage in a for-profit activity in anticipation of that activity becoming an active business. To qualify for the election, an expense also must be one that would be deductible if it were incurred after a business began. One example is money you spend analyzing potential markets for a new product or service. To be eligible as an “organization expense,” an expense must be related to establishing a corporation or partnership. Some examples of organization expenses are legal and accounting fees for services related to organizing a new business and filing fees paid to the state of incorporation.

If you have start-up expenses that you’d like to deduct this year, you need to decide whether to take the election described above. Record-keeping is critical.

To see how ATA can help grow your emerging business, visit our website. © 2021

Categories
Tax

Tax Advantages of Hiring Your Child at Your Small Business

As a business owner, you should be aware that you can save family income and payroll taxes by putting your child on the payroll. Here are some considerations.

Shifting business earnings

You can turn some of your high-taxed income into tax-free or low-taxed income by shifting some business earnings to a child as wages for services performed. In order for your business to deduct the wages as a business expense, the work done by the child must be legitimate and the child’s salary must be reasonable.

For example, suppose you’re a sole proprietor in the 37% tax bracket. You hire your 16-year-old son to help with office work full-time in the summer and part-time in the fall. He earns $10,000 during the year (and doesn’t have other earnings). You can save $3,700 (37% of $10,000) in income taxes at no tax cost to your son, who can use his $12,550 standard deduction for 2021 to shelter his earnings. Family taxes are cut even if your son’s earnings exceed his standard deduction. That’s because the unsheltered earnings will be taxed to him beginning at a 10% rate, instead of being taxed at your higher rate.

Income tax withholding

Your business likely will have to withhold federal income taxes on your child’s wages. Usually, an employee can claim exempt status if he or she had no federal income tax liability for last year and expects to have none this year. However, exemption from withholding can’t be claimed if: 1) the employee’s income exceeds $1,100 for 2021 (and includes more than $350 of unearned income), and 2) the employee can be claimed as a dependent on someone else’s return.  Keep in mind that your child probably will get a refund for part or all of the withheld tax when filing a return for the year.

Social Security tax savings

If your business isn’t incorporated, you can also save some Social Security tax by shifting some of your earnings to your child. That’s because services performed by a child under age 18 while employed by a parent isn’t considered employment for FICA tax purposes. A similar but more liberal exemption applies for FUTA (unemployment) tax, which exempts earnings paid to a child under age 21 employed by a parent. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting only of his or her parents.

Note: There’s no FICA or FUTA exemption for employing a child if your business is incorporated or is a partnership that includes non-parent partners. However, there’s no extra cost to your business if you’re paying a child for work you’d pay someone else to do.

Retirement benefits

Your business also may be able to provide your child with retirement savings, depending on your plan and how it defines qualifying employees. For example, if you have a SEP plan, a contribution can be made for the child up to 25% of his or her earnings (not to exceed $58,000 for 2021).

Contact your ATA representative if you have any questions about these rules in your situation. Keep in mind that some of the rules about employing children may change from year to year and may require your income-shifting strategies to change too. © 2021

Categories
News

New Changes to PPP Released

New reforms to the second round of Paycheck Protection Program (PPP) loans were recently announced in an effort to give more small businesses access to PPP funding. The changes benefit the smallest of businesses as well as organizations that were not included in the first round of relief. The changes are outlined in the following paragraphs.

 

As of January 17, 2021, self-employed farmers and ranchers (Schedule F filers) are now allowed to utilize gross income (Schedule F line on Form 1040) of up to $100,000 to qualify for the PPP. Before this change, net income (Schedule F line on Form 1040) was used to qualify.

 

Sole proprietors, independent contractors and self-employed individuals (Schedule C filers) can use gross income to qualify for the PPP; as with farmers and ranchers, these Schedule C filers previously utilized net income to qualify. These changes are not retroactive for borrowers that have already received a PPP loan.

 

Small businesses with less than 20 employees have a 14-day window ranging from Wednesday, February 24, 2021 at 9 a.m. ET to Tuesday, March 9, 2021, at 5 p.m. ET to apply for PPP loans. Applications submitted by businesses with less than 20 employees before the exclusivity period will still be processed. During this period, applications from organizations with more than 20 employees will be put on hold to allow for more focus on smaller businesses.

 

Ask your CPA if you are using the appropriate calculations for PPP relief. Contact us at ata.net/locations.

 

Sources & more information:

White House Briefing

SBA Resource

SBA Calculations

SBA Business Loan Program Temporary Changes; Paycheck Protection Program

 

 

 

 

Categories
Financial Institutions and Banking News

Breaking Up Is Hard To Do

Protect Bank Interests After a Divorce
Privately owned family businesses typically make up a significant portion of community banks’ loan portfolios. Often, such businesses are co-owned by two partners — who are also married. If the marriage falls apart, will the business follow suit? There are several factors to be aware of if your bank’s loans are at risk due to divorce.
Control and goodwill matter
Sometimes one spouse controls the business, and the other spouse pursues outside interests. A key question in these cases is how much of the private business interest to include in the marital estate. The answer is a function of purchase date, prenuptial agreements, length of marriage, legal precedent and state law.
Goodwill is another point of contention. If a business has value beyond its tangible net worth, how is intangible “goodwill” split up? All goodwill is included in (or excluded from) the marital estate in some states. But about half the states divide goodwill into two pieces: business goodwill and personal goodwill. The latter is excluded from value in these states.
Accurate valuations and reasonable payout periods are important. Settlements that disproportionately favor the noncontrolling spouse can drain company resources and cause financial distress. If the parties can’t reach an equitable settlement, it’s also possible for the court to mandate a liquidation, which threatens business continuity.
When the company buys out a spouse, Treasury stock might appear on the customer’s balance sheet. Or you might see an increase in shareholder loans if the owner-spouse borrows money from the business to pay divorce settlement obligations.
Avoidance strategies can backfire
The noncontrolling (or nonmonied) spouse also may receive alimony and child support from the controlling shareholder. Maintenance payments typically are based on the owner’s annual salary, bonus and perks.
Unscrupulous owner-spouses may try to change compensation levels in anticipation of divorce. Depending on the type of entity they own, a lower wage level may benefit them in negotiations for spousal maintenance and child support.
Also be aware that what divorcing borrowers say about unreported revenues, below-market compensation and personal expenses run through the business could lead to negative tax consequences. Publicly admitting these tax avoidance strategies puts both spouses and the business at risk for IRS inquiry, which could lead to difficulties repaying the loan.
Buyout plans can prevent dissolution
Many private businesses are run by both spouses, whose complementary skill sets make for a hard decision: Who’s going to run the business after the divorce? In limited cases, the spouses may want to continue to run the business together. Like most stakeholders, if co-owners decide to split up personally, but maintain their professional relationships and continue co-managing the business, you may be rightfully skeptical about their future business relationship. Usually, however, the parties can’t imagine working with each other. Such a scenario requires a buyout and a non-compete agreement.
Buyouts should occur over a reasonable time period and can include an earnout — wherein a portion of the selling price is contingent on future earnings — to avoid undue strain on the business. Future success is uncertain when a business loses a key person. It’s fair for both shareholders to bear that risk. If they don’t, the remaining owner, and your bank, could be at risk.
Even if your family-owned business borrowers aren’t currently contemplating divorce, consider what might happen if they did. Proactive family businesses have a buy-sell agreement in place before personal relationships sour. Factors to consider include valuation formulas and methods, valuation discounts, earnout schedules, postbuyout consulting contracts, non-compete agreements and payment of appraisal fees.
Staying engaged with borrowers is key
Keeping your bank’s loans stable and profitable requires you to stay aware of many issues that might crop up for your borrowers over time — including divorce. If you stay on top of potential problems, you’re likely to be able to help your borrowers navigate these difficult waters and come out relatively unscathed, protecting your loans in the process. Visit our financial institutions’ page to connect with an expert.  © 2020