Magazine article The CPA Journal

Home-Based Business Deductions Are Not Always Legal

Magazine article The CPA Journal

Home-Based Business Deductions Are Not Always Legal

Article excerpt

Many ideas on how to reduce taxes are simply overlooked deductions that may be brought to mind by a newspaper or magazine article. Other times, the ideas are promoted by tax scam artists. Many erroneous beliefs have been used as justification to avoid federal income taxation; for example, the tax system is voluntary.

A less radical idea is that a home-based business can save tax dollars. If a legitimate business based in the taxpayer's home incurs an operating loss, then there is a tax savings. Unfortunately, tax scam promoters promise deductions for expenditures that are not legitimately deductible.

Hobby Deductions

An activity may be classified by the IRS as a hobby regardless of what the taxpayer calls it. The distinction between a business and a hobby is vitally important. A business may incur an operating loss during a tax year. This loss can offset income from other sources if the taxpayer or the taxpayer's spouse works in the business more than 500 hours during the year or works substantially all of the hours required to operate the business. According to the Individual Income Tax Returns Preliminary Data in 2001, taxpayers filed approximately 17.6 million returns that included business or professional activity, and 24% of those returns reported a deductible operating loss.

A loss from a hobby activity, on the other hand, is not deductible and cannot offset other sources of income. The full amount of hobby revenue is included in a taxpayer's gross income. If a taxpayer chooses to itemize deductions on Schedule A, then hobby expenses may be deductible, but only up to the amount of hobby revenue. Therefore, a taxpayer can never have a hobby loss. Taxpayers must offset hobby revenue with hobby expenses in this specific order: 1) mortgage interest and property taxes attributable to the hobby, 2) normal business expenses (e.g., salaries, office supplies, advertising), and 3) depreciation.

Allowable hobby expenses are combined with other miscellaneous deductions, such as unreimbursed employee business expenses, tax preparation expenses, and investment expenses (other than investment interest expense). The total of these miscellaneous deductions is then reduced by 2% of the taxpayer's adjusted gross income (AGI). Any excess deductions over 2% of AGI are added to other itemized deductions. If a taxpayer uses the standard deduction rather than itemizing on Schedule A, then hobby expenses are not deductible.

Is It a Business?

Given that the distinction between a business and a hobby is critical to taxpayers, it is essential to understand the factors the IRS uses to make a determination. Treasury Regulations section 1.183-2 identifies nine relevant factors to distinguish between a business and a hobby:

* The manner in which the taxpayer carries on the activity, e.g., maintaining accurate books and records;

* The expertise of the taxpayer or the taxpayer's advisors;

* The time and effort expended by the taxpayer in operating the activity;

* The expectation that assets used in the activity may appreciate in value;

* The history of success of the taxpayer in other activities;

* The history of income and losses in this activity;

* The amount of occasional profits, if any, that are earned;

* The financial status of the taxpayer-that is, if this activity is the taxpayer's only source of income, the IRS is more inclined to consider the activity a business-and

* The elements of personal pleasure or recreation involved.

In the regulations, none of these factors is given more weight than another and there is no formula to ensure classification as a business. Taxpayers and the IRS often disagree about the proper classification of an activity. There are a plethora of court cases on this issue. Relying on just one decision would be ill advised. The facts of each case are distinct and usually give the reader only an indication of how the IRS might rule under vety specific circumstances. …

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