How to ensure your business is not deemed a hobby

You Can't Deduct that Loss. It's a Hobby.

You’ve loved dogs all your life so you decide to breed them and start a dog training business. Is this a business in the eyes of the IRS or a hobby? Knowing what the IRS is looking for and properly positioning your small business can save taxes and headaches if you are ever questioned by the IRS.

Why should you care?

If your activity is a business your income can be reduced by all your qualified business expenses even if it results in a loss. If your activity is a deemed a hobby, no losses are allowed on your tax return. Furthermore, your hobby expenses are treated as miscellaneous itemized deductions and do not count until they (and other miscellaneous expenses) surpass 2% of your income.

Tips to make it a clear business

Here are some simple tips to ensure full deductibility of your expenses against your business income.

1. Profit motive. You must show that you intend to make a profit with your activity. The old rule of thumb was to show a profit at least three out of the past five consecutive years to safely qualify your activity as a small business. But this is no longer the case. Although more difficult to substantiate, you can show profit motive without ever showing a profit by your ongoing activities around the business.
2. Active participation. You need to be actively involved in your pursuit for success. If you simply invest money in the dog business, but are never there to care for them or give lessons, you will have a hard time justifying the business nature of the activity.
3. Be professional. Businesses have separate checkbooks, business cards and stationery. They have financial statements and show the same disciplines one would find in a “for profit” venture of the same type of activity you are pursuing.
4. Pleasure factor management. If your business has a large enjoyment factor, you will need to be even more cautious about having proper records. Ideally the pleasure factor is secondary to running your business. If you claim to be a golf pro giving lessons, but then spend all your time playing golf, you will have a hard time justifying the activity as a true business.
5. Have multiple customers. If you only have one or two customers, who also happen to be relatives, your activity may be deemed a hobby. Having a number of customers, even without profits, can make all the difference in allowing for expense deductions.
6. Showing profit motive without profits - Part II. How else can you show profit motive when no profit is to be found? Advertising is one way to do this. Keep copies of all ads trying to drum up business. Keep a daily diary of business activities, noting who you meet and for what purpose. Create and keep sample product, even if it is not yet sold.
7. Understand your risk. There are certain business types that are under the IRS microscope when it comes to hobbies. Key among these are multi-level marketing businesses like Amway, Tupperware and Avon. It also includes the thousands of part-time sellers of goods on internet sites like e-bay. If you are in one of these business activities you will need to prove the business nature of your involvement and be prepared to be challenged.

Quick Checklist

Wondering if your business activity may be considered a hobby? Review this checklist. The more yes answers, the better your chances of defending your position.

• Conducted activity in business-like manner?
• Have expertise in your activity?
• Put time and effort into the activity?
• History of income/profits?
• Have had prior success in a similar activity?
• Is there a low element of pleasure/recreation involved?
• Are there appreciating assets or an expectation that there will be?

Remember, having a business activity reclassified as a hobby can mean a big tax bite at tax time. But by keeping proper records and pro-actively knowing the pitfalls, you can avoid most problems.

What to do about your need for documentation

No Check! Where's Your Proof?

Year-end is a good time to ensure you have proper documentation to substantiate your tax deductions. This is important as many banks start deleting online documentation that is over one year old.

Background

Two things have happened over the past ten years that have greatly reduced the ability to have a canceled check as proof when the auditor comes calling. The first is the advent of online bill paying services. The second is a regulation that was passed in 2003 commonly known as Check 21. With online bill paying, you pay a bill via an online banking service. Your only receipt is often just an entry in your checking account. With Check 21, the law allows banks to digitally capture the check and then destroy the paper copy without returning it to you. So what do you do if you need proof that you paid for a tax deductible item?

Some Tips

• Know your bank. Understand what your bank keeps and for how long. This includes digital statements and digital copies of checks (both front and back). Understand if there are any fees charged if you need to request copies of payments.

• Retain copies of all bank statements. Review your records to ensure you have copies of all monthly bank statements. This is often the starting point for an IRS agent that wants proof of payment, so it should be yours as well. These copies may be in either paper or digital format. Download online copies of your statements and place them in a password protected file.

• Collect copies of tax related proof of payment. Go through your statements and mark the payments that will, in all likelihood, be used as a tax deduction. Make sure you have copies of the front and back of each of these payments. If you do this work now, the copies are often still available online for no fee. Even online bill payments often have a digital copy that can be used.

• Get independent acknowledgements. If you have larger payments you should also make sure you have independent acknowledgement from the merchant or organization to substantiate the deduction. This is true for charitable contributions of $250 or more, and any business or medical expenses.

While having the traditional "proof" of an expenditure is now harder to come by, the IRS understands that approved technologies are changing the type of substantiation available for them to review. By being on top of this documentation at the end of each year, you can save yourself a lot of headaches should you ever need to prove your deductions.

Lower Your Taxes THIS YEAR! Here are 6 ideas that most people can use

While 2012 winds down, there is still time to reduce your tax burden. Here are six ideas that can save money for most of us.

1.   Pre-tax Savings. Take advantage of opportunities to set aside income on a pre-tax basis. This includes participation in company sponsored retirement savings programs, Health Savings Accounts (HSA), and “Flex Benefits” accounts that allow using pre-tax earnings to pay for childcare and out-of-pocket medical costs. Remember, however, unlike HSAs it is important to use up any funds in your Flex health care accounts and dependent care accounts prior to the end of the plan year as any unused funds will be forfeited.

2.   Defer Income and Accelerate Deductions (or vice versa!). When possible think about whether it is better to reduce taxable income in this year or next year. By understanding which tax year will be more advantageous to you, you can act to defer income into a subsequent tax year and accelerate deductible expenses into the current tax year. On the other hand you may believe tax rates will be higher next year. If this is the case you will want to move as much income into the current year and defer expenses.

Here are some ideas if your strategy is to minimize taxable income this year:

o    Delay depositing a bonus check

o    Make an extra house payment

o    Make extra charitable contributions (that you would make anyway)

o    Make next year’s church donations this year.

o    Make extra trips to donate non-cash items prior to January 1^st

o    Review your investments to book gains and/or losses

3.   Make Interest Expense Deductible. Move non-deductible interest expenses (personal credit cards) to deductible interest expense (home equity loans).

4.   Maximize tax-exempt and tax-deferred Investments. The higher your tax bracket the more tax savings you’ll realize with tax exempt and tax deferred contributions such as employer sponsored 401(k)s, IRA’s, tax-free municipal bonds, and Section 529 College Savings Plans.

5.   Navigate Estate Planning. Manage the value of your estate to minimize estate taxes through gifting, trusts, life insurance, annuities, and other estate planning tools.

6.   Avoid Penalties. Avoid costly penalties and interest charges by filing your returns and paying taxes owed on a timely basis, as required by the IRS.

Plus a bonus thought. Look for ways to double dip the tax savings. One of the best examples of this is the donation of appreciated stock (held over one year) to a charitable organization. Not only do you get to deduct the appreciated value of the stock, you also avoid paying capital gains tax on the increased value of the shares.

Contemporaneous Records... Why Should You Care?

Sometimes big IRS related terms can mean BIG trouble

If you have problems getting to sleep at night and you turn to the IRS tax code for help, you might find some vocabulary that is very foreign to words you use every day. One of the more common words used by the IRS is the term "contemporaneous". So what does it mean and why should you care?

Contemporaneous Defined

According to the IRS it means the records used to support a claim on your tax return were created and originated at the same time as your claimed deduction. In other words, if you realize that you forgot to get a receipt for something, you are out of luck if you try to get one at a later date.

Not Fair!

Perhaps you know you had the expense, but you simply forgot to get a receipt. You can cry foul, but time and again the IRS has had tax courts uphold their elimination of a taxpayer's deduction for lack of contemporaneous documentation. Here are some areas where contemporaneous documentation is especially important:

• Charitable contributions
• Business deductions for expenses and capital purchases
• Mileage logs
• Tip records
• Gambling losses
• Traveling and entertainment expenses
• Hobby losses

The donation of vehicles, boats, and planes is often the most cited area where lack of contemporaneous documentation is a problem. This is because the value of this type of donation can be high and the estimated market value could change each month. But timely, written acknowledgement from the charitable organization is also required for any donation of $250 or more.

What you need to know

• Always get a receipt. Before you leave a donated item, always ask for a receipt. In the case of a vehicle, make sure the charitable organization gives you a 1098-C fully filled out. In addition, make sure the organization uses your vehicle or is a qualified charitable group that allows you to take the full market value of your donation.
• If you forget, call right away. As soon as you realize a confirmation or receipt is missing, call to get one sent to you. Request that the receipt be dated as of the date of the service or activity.
• Think tax year. Understanding the definition of contemporaneous is important, because it is not always "precisely" defined. If the documentation is received in the same year as the donation or transaction, you are usually in good shape.
• Keep a log. Many expenses require the correct documentation at the time the activity occurred. This is true with deductible mileage, gambling loses, and documenting your tip income. So keep a log of your activities when they occur.

Wait to file. Often, to meet the IRS definition of contemporaneous, the receipt or acknowledgement must be received the earlier of either; when you file your tax return OR the due date (including extensions) of your tax return. This is particularly true with charitable contributions. So if you want to play it safe, do not file until all documentation is in hand.