Business vs. Hobby: Tax Rules Have Changed

 

fishing_LI-532x266 Business vs. Hobby: Tax Rules Have Changed  If you generate income from a passion such as cooking, woodworking, raising animals — or anything else — beware of the tax implications. They’ll vary depending on whether the activity is treated as a hobby or a business.

The bottom line: The income generated by your activity is taxable. But different rules apply to how income and related expenses are reported.

Factors to consider

The IRS has identified several factors that should be considered when making the hobby vs. business distinction. The greater the extent to which these factors apply, the more likely your activity will be deemed a business.

For starters, in the event of an audit, the IRS will examine the time and effort you devote to the activity and whether you depend on income from the activity for your livelihood. Also, the IRS will likely view it as a business if any losses you’ve incurred are because of circumstances beyond your control, or they took place in what could be defined as the start-up phase of a company.

Profitability — past, present, and future — is also important. If you change your operational methods to improve profitability, and you can expect future profits from the appreciation of assets used in the activity, the IRS is more likely to view it as a business. The agency may also consider whether you’ve previously made a profit in similar activities. Also, the intent to make a profit is a key factor.

The IRS always stresses that the final determination will be based on all the relevant facts and circumstances related to your activity.

Changes under the TCJA

Under previous tax law, if the activity was deemed a hobby, you could still generally deduct ordinary and necessary expenses associated with it. But you had to deduct hobby expenses as miscellaneous itemized deduction items, so they could be written off only to the extent they exceeded 2% of adjusted gross income (AGI).

All of this has changed under the Tax Cuts and Jobs Act (TCJA). Beginning with the 2018 tax year and running through 2025, the TCJA eliminates write-offs for miscellaneous itemized deduction items previously subject to the 2% of AGI threshold.

Thus, if the activity is a hobby, you won’t be able to deduct expenses associated with it. However, you must still report all income from it. If, instead, the activity is considered a business, you can deduct the expenses associated with it. If the business activity results in a loss, you can deduct the loss from your other income in the same tax year, within certain limits.

An issue to address

Worried the IRS might recharacterize your business as a hobby?

Contact our office. We can help you address this issue on your 2019 return or assist you in perhaps filing an amended 2018 return, if appropriate.

Running your Personal Finances Like a Business

woman-money_LI-532x266 Running your Personal Finances Like a Business

Most individuals don’t regard themselves as businesses, trying to turn a profit and beat the competition. But, occasionally, it may help to look at your financial situation this way to determine where you might cut expenses and boost cash flow. Here are some tips.

Lay out your financials

Where an executive might reach for financial statements to get a read on the company’s standing, you can create or update a net worth statement. Essentially a monetary scorecard, a net worth statement helps you determine where you stand financially and whether you’re on track to meet your goals.

You can calculate your net worth by adding all your assets, including cash and cash equivalents, brokerage account balances, retirement funds, real estate, and other fixed assets and personal property. Then subtract your liabilities, including mortgages, personal loans, credit card balances and taxes due.

The result provides some important clues about where your money is going and how you might be able to trim spending and increase savings. Are you over-relying on credit cards with high interest rates? Could you cut back on food or entertainment costs?

Practice risk management

To maintain their companies’ financial health, business executives also practice risk management. You can do the same by first assessing compensation and benefits elections. A major life change — such as a marriage or birth — may require an update to your W-4 withholding allowances with your employer.

Unexpected medical costs can be a huge risk. Review your health insurance to ensure it’s providing the best value. Now might not be an ideal time to switch to a spouse’s plan but, if it’s a better deal, perhaps make a note to do so when you can. Also, if you have a Health Savings Account or Flexible Spending Account, make sure you’re using it to your full advantage.

Think about other insurance, too. Perhaps your home has increased in value, necessitating a corresponding increase in your homeowner’s coverage. Or maybe you no longer have enough life insurance to protect your growing family. Talk to your insurance professional to determine the right amount of coverage.

Finally, check your credit report. If you wait until something is obviously wrong, it may be too late to prevent significant damage. Federal law requires the three major credit reporting agencies to provide you with one free report per year.

Think about retirement

Business owners must think about succession planning. But even if you don’t own a company, you should think about life after employment.

If your employer allows you to adjust your retirement plan contributions during the year, consider boosting them to take full advantage of tax-deferred compounding and, if available, employer matching. Similarly, if you plan to make an IRA contribution this year, do so as early as possible to give your assets more time to grow.

Also, review your estate plan and, if necessary, update it. Financial priorities change over time, so make sure the beneficiary designations for your retirement accounts and insurance policies still match your wishes. Check your will or living trust to ensure no changes are necessary. And, if you’re looking to reduce the value of your taxable estate, remember that you can make $15,000 ($30,000 for married couples) in annual exclusion gifts per recipient this year without using up any lifetime exemption.

Get rolling

Some might say that the beginning of the year is the most important time for financial planning. Others might say it’s at the end of the year when you start preparing to file your tax return. In truth, the whole year is important. And right now, with the arrival of spring and the year well underway, is a perfect time to adjust objectives set a few months ago — and really get rolling.

Contact us for help.

Are you considering forming a C Corp?

business-desk_LI-532x266-1 Are you considering forming a C Corp?

Many owners of private companies have been leery of operating as a regular C corporation. If you make that choice, you will be exposed to double-taxation of business income.

First, a corporate income tax applies to the company’s profits. Second, any dividends that pass to you and other shareholders will be subject to personal income taxes. Making matters even more expensive, your C corporation won’t get an income tax deduction for the dividends it pays out.

Tax Pain Relief

The Tax Cuts and Jobs Act (TCJA) of 2017 has made this tax parlay easier to bear. Personal income tax rates generally have come down: the top federal rate, from now through 2025, has been lowered from 39.6% to 37%, for example.

During these years, corporate income will be taxed at a flat 21%, regardless of the amount. (Formerly, there was a graduated tax schedule, going up to 35%.) These tax rate reductions, combined with the retention of the 15% or 20% tax rates on qualified dividends received (which are based on the capital gains rates), may make it cost effective to operate your business as a C corporation.

Example: Mike Morton owns 100% of a C corporation, which has a $100,000 profit this year. The company pays $21,000 in corporate income tax, at 21%, and pays the $79,000 balance as a dividend to Mike.

Assume Mike and his wife Nora owe the maximum 20% tax rate on the dividend, as well as the 3.8% net investment income tax on that dividend: 23.8% of $79,000, or about $18,800. Altogether, the total tax on that $100,000 of company profits is $39,800, which is much less than it would have been, under the 2017 tax rates.

Pros and Cons

Other factors should be weighed when deciding on a business entity. For example, C corporations have some tax advantages, such as the ability to deduct the cost of certain fringe benefits and not pass on imputed income to significant shareholders.

At the same time, C corporations pose other tax perils. Owners may have to contend with possible unreasonable compensation (paying too much in salary and bonus) and excess accumulated earnings (saving too much, rather than paying dividends) issues.

We Can Help

Our staff can help you put numbers on all of these looming tax traps, so you can make an informed decision. Give us a call before you solidify the formation of your business.

How To: Trim the Inventory Fat

Inventory-costs_LI-532x266 How To: Trim the Inventory Fat
Photo: Samuel Zeller

Inventory is expensive. Here are some ways to trim the fat from your inventory without compromising revenue and customer service.

Objective Inventory Counts

Effective inventory management starts with a physical inventory count. Accuracy is essential to know your cost of goods sold — and to identifying and remedying discrepancies between your physical count and perpetual inventory records. A CPA can introduce an element of objectivity to the counting process and help minimize errors.

The next step is to compare your inventory costs to those of other companies in your industry. Trade associations often publish benchmarks for:

  • Gross margin ([revenue – cost of sales] / revenue),
  • Net profit margin (net income/revenue), and
  • Days in inventory (annual revenue / average inventory × 365 days).

Your company should strive to meet — or beat — industry standards. For a retailer or wholesaler, inventory is simply purchased from the manufacturer. But the inventory account is more complicated for manufacturers and construction firms. It’s a function of raw materials, labor, and overhead costs.

The composition of your company’s cost of goods will guide you on where to cut. In a tight labor market, it’s hard to reduce labor costs. But it may be possible to renegotiate prices with suppliers.

And don’t forget the carrying costs of inventory, such as storage, insurance, obsolescence, and pilferage. You can also improve margins by negotiating a net lease for your warehouse, installing anti-theft devices or opting for less expensive insurance coverage.

Product Mix

To cut your days-in-inventory ratio, compute product-by-product margins. Stock more products with high margins and high demand — and less of everything else. Whenever possible, return excessive supplies of slow-moving materials or products to your suppliers.

Product mix should be sufficiently broad and in tune with consumer needs. Before cutting back on inventory, you might need to negotiate speedier delivery from suppliers or give suppliers access to your perpetual inventory system. These precautionary measures can help prevent lost sales due to lean inventory.

Reality Check

Often management is so focused on sales, HR issues and product innovation that they lose control over inventory.

Contact us for a reality check.

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Sales Tax and the Out-of-State Buyer

qtq80-vJG8zn-1024x680 Sales Tax and the Out-of-State Buyer

If your company makes sales to out-of-state buyers, do you need to collect state sales tax? Until recently, Supreme Court decisions from the 20th-century declared that would not necessarily be the case.

Example 1: ABC Corp., based in Alabama, sends a catalog to customers and prospects. A consumer who lives in Wyoming places a $100 order.

Assume that ABC has neither employees nor property in Wyoming. ABC would not be required to collect Wyoming sales tax on the $100 purchase price and remit to Wyoming under those Supreme Court decisions because ABC had no “physical presence” in that state. (Wyoming, like most states, requires consumers to pay a use tax instead of a sales tax, but states have found it difficult to enforce compliance with their use taxes.)

Because they must collect sales tax, in-state retailers have been at a significant disadvantage versus out-of-state sellers who don’t collect sales tax.

South Dakota v. Wayfair

The 20th-century reasoning of the physical presence requirement did not recognize the realities of the 21st century, a divided (5-4) Supreme Court found earlier this year. In South Dakota v. Wayfair, Inc., 6/21/18, the Court held that the physical presence requirement no longer applied, paving the way for enforcement of a South Dakota law that requires many “remote” sellers to collect applicable sales tax on purchases by South Dakota residents.

The majority in the Wayfair decision pointed to some favorable aspects of the South Dakota law. For one, it applies only to remote sellers with at least 200 transactions or $100,000 in revenue from South Dakota buyers in a calendar year. Therefore, a company that occasionally ships a few moderately priced items across state lines needn’t master all the sales tax rules pertaining to South Dakota buyers and collect the tax and remit it to the state.

In addition, South Dakota is a party to the Streamlined Sales and Use Tax Agreement, which reportedly has 24 member states. This agreement, designed to standardize taxes in order to reduce administrative and compliance costs, provides sellers access to sales tax administration software.

Going Forward

After this Supreme Court decision, many (perhaps most) states will consider new legislation that requires out-of-state vendors to collect and forward sales tax, even without a physical presence in the buyer’s state. However, Congress might pass a federal law addressing the issue of interstate sales tax collection.

If no federal law is passed, the focus will remain on states’ actions. Assuming that states follow the format of the South Dakota law, companies that do a minimum amount of online retailing may not be greatly affected.

Contact Us

Conversely, small businesses that do a great deal of online selling, or plan to do so, might have to make extensive efforts to collect and forward sales tax to multiple states. We can help such companies comply with any requirements that arise. Contact us for help and guidance.

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