Featured Articles For October, 2011
Hobby or Business? Why It Matters
Tax Tips
Late Filing Penalties for S-Corp, Partnership Returns
Advantages of Keeping Good Records
College Tax Credit - It's Not Too Late!
QuickBooks Tips
Classes or Types? When To Use Them in QuickBooks
Financial Planning Tips
Asset Allocation Adjustments
Health Spending Checkup
Review Budget vs. Actuals
Estimate Your 2011 Tax Liability
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:
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Does the time and effort put into the activity indicate an intention to make a profit?
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Do you depend on income from the activity?
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If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
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Have you changed methods of operation to improve profitability?
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Do you have the knowledge needed to carry on the activity as a successful business?
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Have you made a profit in similar activities in the past?
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Does the activity make a profit in some years?
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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:
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Deductions that a taxpayer may claim for certain personal expenses, such as home mortgage interest and taxes, may be taken in full.
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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.
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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.
Give us a call if you're not sure whether your hobby is actually a business and we'll help you figure it out.
Late Filing Penalties for S-Corp, Partnership Returns
Penalties for S-Corps, Partnerships, and Fiduciaries failing to file returns have been steadily rising, but starting in tax year 2010 penalties for S-Corp, Partnership, and Fiduciary filing late returns increased to $195.
The IRS states that for returns on which no tax is due, the penalty is $195 for each month or part of a month (up to 12 months) the return is late multiplied by the total number of persons who were shareholders in the corporation during any part of the corporation's tax year for which the return is due. The penalty may also be charged if the return does not show all the information required.
For example, if a S-Corporation fails to file its 2010 return (including a Schedule K-1 to each shareholder) on time the penalty could be as much as $2,340 per shareholder per year ($195 per shareholder for the maximum of 12 months).
These failure-to-file penalties do not include tax that is due or penalties for tax that is due, but not paid on time. Add in the fact that the penalty isn't tax deductible on your tax returns the following year and you've got yourself a double whammy.
If the partnership or S-corporation can show that the failure to file on time was due to "reasonable cause", the IRS might provide relief. Be advised however, that if the partnership or S-corporation has established a pattern of failing to file in the past, it's unlikely that the IRS will be sympathetic.
Why take a chance? If you need assistance filing your S-Corp, Partnership, or Fiduciary return, call us today.
Advantages of Keeping Good Records
You can avoid headaches at tax time by keeping track of your receipts and other records throughout the year. Good record-keeping will help you remember the various transactions you made during the year, which in turn may make filing your return less, well, taxing.
Records help you document the deductions you've claimed on your return. You'll need this documentation should the IRS select your return for examination. Normally, tax records should be kept for three years, but some documents - such as records relating to a home purchase or sale, stock transactions, IRA, and business or rental property - should be kept longer.
In most cases, the IRS does not require you to keep records in any special manner. Generally speaking, however, you should keep any and all documents that may have an impact on your federal tax return:
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Bills
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Credit card and other receipts
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Invoices
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Mileage logs
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Canceled, imaged, or substitute checks or any other proof of payment
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Any other records to support deductions or credits you claim on your return
Good record-keeping throughout the year saves you time and effort at tax time. For more information on what kinds of records you should keep, call our office.
College Tax Credit - It's Not Too Late!
It's not too late to take advantage of the American Opportunity Tax Credit, a credit that helps parents and college students offset the cost of college. This tax credit is part of the American Recovery and Reinvestment Act of 2009 and is available through December 31, 2012. It can be claimed by eligible taxpayers for college expenses paid until 2012.
Here are six important facts about the American Opportunity Tax Credit:
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This credit, formerly known as the Hope Credit, has been expanded. Eligible taxpayers can claim qualified tuition and related expenses paid for higher education through 2012. Qualified tuition and related expenses include tuition, related fees, books, and other required course materials.
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The credit is equal to 100 percent of the first $2,000 spent per student each year and 25 percent of the next $2,000. Therefore, the full $2,500 credit may be available to a taxpayer who pays $4,000 or more in qualifying expenses for an eligible student.
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The full credit is generally available to eligible taxpayers who make less than $80,000, or $160,000 for married couples filing jointly. The credit is gradually reduced, however, for taxpayers with incomes above these levels.
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Forty percent of the credit is refundable, so even those who owe no tax can get up to $1,000 of the credit for each eligible student as cash back.
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The credit can be claimed for qualified expenses paid during any of the first four years of post-secondary education.
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You cannot claim the tuition and fees tax deduction in the same year that you claim the American Opportunity Tax Credit or the Lifetime Learning Credit. You must choose to take either the credit or the deduction.
If you would like more information about the American Opportunity Tax Credit please call us. We're more than happy to help.
Classes or Types? When To Use Them in QuickBooks
QuickBooks' standard reports are critical to understanding your company's past, present, and future. But the program also offers innovative tools that can make them significantly more insightful and comprehensive.
QuickBooks offers two simple conventions that let you identify related data: classes and types. Classes are used in transactions. Types are assigned to individual customers, vendors, and jobs.
For example, you might use classes to separate transactions that relate to different departments, locations, or types of business. A construction company might want to track classes using New Construction, Remodel, and Overhead. Your customer types might help you isolate groups by characteristics like Industry or Geographical Location.
Creating Classes
First, make sure that QuickBooks is set up to use classes. Go to Edit | Preferences | Accounting | Company Preferences. Make sure that Use class tracking is checked. If you want to be prompted for a class designation in transactions, check that box, too. QuickBooks already contains a Type field in customer, vendor, and job records.
It's easy to build lists of options for both. To define classes, go to Lists | Class List. In the bottom left corner of the screen, click on Class, then select New from the menu. You'll see this:
Figure 1: To create a class, just give it a name and click OK
Let's say that you're a contractor and you want to separate remodeling jobs into room types, like Bathroom or Kitchen. Go through the above steps again. Enter "Bathroom" in the Class Name field and click the box next to Subclass of. Open the list and choose "Remodel." Click OK.
Tip: If your class list grows lengthy and you want to tidy it up, you can make classes that you're not currently using inactive by checking the box in this window. It will remain in your QuickBooks records and can be reactivated again.
Putting Classes to Work
Now you can use classes in transactions. Open a blank invoice and select a customer. The Class field will be next to the customer name. If the entire invoice will be assigned to the same class, click the drop-down list and select it. You can also assign separate classes to individual line items:
Figure 2: You can assign different classes to individual line items in transactions.
Not all invoice templates include a column for classes. You can add this by selecting the invoice form you want to modify and clicking Customize in the toolbar.
QuickBooks comes with two reports specially designed for tracking class-based transactions: Profit & Loss by Class and Balance Sheet by Class (both can be found in the Reports menu, under Company & Financial). Of course, you can filter other reports to include a class column. You can also create a QuickReport for individual classes. Go to Lists | Class List and select a report or graph.
Figure 3: You can filter by class in QuickBooks reports.
Warning!
The Balance Sheet by Class report is complicated and may produce unexpected results. Let your ProAdvisor help you work with this one. They can also help you set up a solid class structure.
A Simpler Assignment
Customer, vendor, and job types are a bit less complicated. Job types are especially useful; you can track, for example, profitability and time spent on individual projects. Customer and vendor types can produce output for things like targeted mailings and reports.
Creating types is very similar to creating classes. Go to Lists | Customer & Vendor Profile Lists, and select the type you want to work with. You'll follow the same instructions here as you did for classes. Types do not appear on transactions; they're designed for your own internal use, and they're stored in records.
Figure 4: Customer, vendor, and job types are specified in their records.
Classes and types can be used very effectively in your bookkeeping, but they require a good deal of thought and planning upfront to get accurate, meaningful reports. Let your ProAdvisor know if he/she can assist as you attempt to use these powerful forms of classification.
Financial Tips for October 2011
Asset Allocation Adjustments
Review the asset allocation of your portfolio.Increases and decreases in the value of your portfolio can upset the asset allocation you consider optimal. Should you shift some stock investments into or out of bond investments? Should you shift some funds into tax-free investments?
Health Spending Checkup
If your employer has a flexible spending arrangement (FSA), determine the balance left in the plan. Your plan may allow you to carry over a year-end balance for use early in the following year.
If your plan doesn't allow unspent money to be carried over, then you may want to incur discretionary medical, dental, or optical costs prior to year-end. If you do not participate in such a plan, find out if one is available at your company. Also find out if you are eligible for a Health Savings Account.
Review Budget vs. Actuals
Compare September income and expenditures with your budget. Make adjustments as appropriate to your October expenditures. Make sure you have invested your planned savings amount for September.
Estimate Your 2011 Tax Liability
Total up your taxable income, capital gains, and deductions through this date. Estimate the amounts expected through year-end. Determine where you stand, and what steps, if any, you should take prior to year-end to minimize your tax liability. Please feel free to call our office if you need help figuring this out.
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