Glossary: Hobby Loss Rules

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Image courtesy of user SaskiaAleida on Pixabay.com

In tax terminology, a hobby is an activity that is NOT engaged in for profit.

This is important because deductions for hobbies are limited, whereas deductions are (generally) unlimited for business activities engaged in with a for-profit motive.

Here’s an example of the difference.

Joe operates a business. He takes in $10,000 and spends $15,000 in business expenses. On his tax return, Joe can deduct a $5,000 loss.

Now let’s say Joe has not been operating his business with a profit motive. This is where the hobby rules kick in.

Joe must claim the $10,000 as income on his tax return. The $15,000 of expenses can be claimed with the following limitations: 1) the deduction is limited to the amount of income from the hobby ($10,000 in this case); 2) the deduction can only be taken as a miscellaneous itemized deduction; 3) only the portion that exceeds 2% of Joe’s adjusted gross income can be taken as a deduction; and 4) if Joe is subject to alternative minimum tax, the deduction is not allowed for AMT.

What If Your Hobby Generates a Profit Instead of a Loss?

Do the hobby rules apply if your income from the hobby is greater than your expenses? I’ve seen accountants argue about this on message boards. I believe the answer is yes, these rules apply even if you end up with a profit from the activity instead of a loss.

Choosing a Business Entity: What is Basis?

Image courtesy of user Geralt on Pixabay.com
Image courtesy of user Geralt on Pixabay.com

This is an excerpt from a presentation I give to college students and to prospective entrepreneurs about types of business entities.

A college professor (who’s also an attorney) told me that my presentation on this subject is the best, clearest and most-concise overview of the topic that she’s ever seen.

I’m flattered by the compliment, and will try to translate those positives into a series of blog posts.

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What is basis? I’ll attempt to answer that question in this post.

First of all, for the tax pros out there who read this blog and the other tax nerds who read this blog: this is a very basic and simplified overview of basis.

The Way I Explain Basis

At its simplest, basis is how much money and property you’ve put into the business, plus or minus the yearly profit or loss from the business, minus what you take out of the business,.

Example:

You and John are 50/50 owners of a partnership that you started this year. You put in $10,000 of cash at startup. John put in $10,000 worth of equipment. During the year, the partnership turned a profit of $30,000. You withdrew $5,000 while John withdrew $0.

Here’s how your and John’s basis is calculated:

You

  • $10,000 initial investment
  • Plus $15,000 (your 50% share of the partnership’s profits)
  • Minus $5,000 of withdrawals
  • EQUALS: $20,000 ending basis

John

  • $10,000 initial investment
  • Plus $15,000 share of partnership profits
  • EQUALS: $25,000 ending basis

Why is Basis Important?

Basis is important for two reasons:

  1. If you sell your partnership interest, your gain or loss from the sale will depend on your basis
  2. In Part 3 I mentioned that withdrawals from a partnership are tax-free. That’s true … if you have enough basis to cover the withdrawal.

The term basis may come up again in our discussion of business entities. We haven’t gotten to S-corporations and C-corporations yet, but here’s how this discussion applies to them:

  • S-corp: the basis calculation is basically the same as shown in this post
  • C-corp: basis will almost always be what the shareholder originally paid for the stock, plus any additional money paid in. Withdrawals will probably be called a dividend (or a salary) and wouldn’t affect basis.

Due Date of Iowa Partnership and Corporate Tax Returns Unchanged

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Image courtesy of user Geralt on Pixabay.com

The due dates for partnership and corporate federal tax returns is changing starting with 2016 filings (so for tax season 2017),  but the due dates for the corresponding Iowa tax returns will not change.

Federal Changes for Businesses with December 31 Year Ends:

  1. For partnerships: the federal due date will change from April 15th to March 15th
  2. For C-corporations: the federal due date will change from March 15th to April 15th
  3. For S-corporations: the federal due date remains unchanged at March 15th

How This Affects Iowa Filings

The Iowa filing deadlines remain unchanged. The due date for ALL entity tax returns with December 31 year ends remains April 30th, same as it’s always been.

Further Reading

For more info about the federal changes, check out this article from CPA Practice Advisor.

For more info about Iowa due dates for business entities, check out this bulletin from the Iowa Department of Revenue.

Things a Business Owner Needs to Know Before Hiring Employees

maze-48698_1280I often say that hiring employees may be the worst thing a small business can do. What I really mean is, hiring employees without knowing what you’re getting into is the worst thing a business can do.

Tax Considerations of Hiring Employees:

  1. You’ll need to get set up with the IRS and the state for withholdings and payroll taxes
  2. You’ll need to withhold taxes from your employees’ pay each payday
  3. Your company will owe payroll taxes on the wages you pay to the employees
  4. You’ll need to submit those withholdings and payroll taxes to the government periodically

Other (Non-Tax) Considerations:

  1. You’ll probably need to have workers’ comp insurance. This can get expensive, especially if your employees are performing manual labor or working on roofs.
  2. There are all sorts of HR issues to deal with. Someone has to manage the employees, determine work schedules, determine how much vacation time they get, and on and on it goes. Managing employees is hard, and the task of managing will generally fall on your shoulders as the business owner, at least at first.
  3. Can you afford to consistently pay employees? If you hire employees, you better be able to make payroll each payday. You also need to put some thought into whether or not you can keep the employee busy — and paid — long-term.
  4. Can you afford to consistently pay the payroll taxes? The government gets very grumpy when you fall behind on your payroll tax deposits.

So to repeat: I’m not saying “don’t hire employees.” What I’m saying is: know what you’re getting into before you hire employees.

Image courtesy of user Nemo on Pixabay.com

Does a Sole Proprietorship Need a Balance Sheet?

Image courtesy of user stevepb on pixabay.com
Image courtesy of user stevepb on pixabay.com

In an online discussion board of tax professionals who use the same software as me, a discussion caught my attention last year relating to whether a tax pro should create a balance sheet for a sole proprietorship.

In that discussion, some preparers said they always prepare a balance sheet for sole proprietorships. These commenters implied that any preparer who does otherwise is not a good preparer.

I agree with preparing a balance sheet and general ledger for entities (partnerships and corporations). In fact, I’ve been fighting this battle with my entity clients for almost a year now.

It’s hard to convince a small business owner who’s been used to keeping his corporate books on a spreadsheet (or worse yet, a spreadsheet that the owner prints out and then scrawls handwritten notes — in pencil! — in the margins) that it’s useful to actually have a true general ledger. But I’m fighting the fight.

One fight I won’t fight, though, is doing this with sole proprietors.

I’ve done balance sheets before for the rare proprietor who actually keeps everything separate.

But how does one even do a balance sheet for your typical sole proprietor where business and personal funds are often intermingled? Yes, it can be done. In fact, there’s guidance in one of my accounting guidebooks on how to prepare sole proprietorship financial statements under Generally Accepted Accounting Principles for a proprietorship with mingled personal and business funds.

So it can be done.

But for the typical sole proprietor, I don’t think it makes much sense.

I’m curious what other tax pros do. Like I said, I am re-educating my corporate and partnership clients who present me with a spreadsheet of income and expenses.

Clearly a true business entity needs a general ledger and balance sheet. But I think sole proprietorships are the one type of entity where a spreadsheet or even a handwritten summary can work.

The proprietorship is not a separate entity. There’s money the proprietor makes in the course of conducting business, and there are business-related expenses. The proprietor can withdraw money at any time, but it’s a tax nothing. Unlike a partnership or a corporation, there’s no equity or basis that needs tracked and accounted for.

I’m all for accuracy and keeping clean books. I just think a balance sheet is overkill for most sole proprietors.

Thoughts?