Cliff Beacham CPA | email cliffbeacham@cpa.com |
California | Tel: (949) 813-1349
State Tax Refunds
Some hobbies generate income; some may eventually develop into
a business
The IRS treats hobbies differently from a trade or business. The crux
of the matter is that the IRS does not want a taxpayer to be able to
write off hobby expenses by calling them trade or businesses
expenses
So, the first question is whether the activity is a hobby or a trade or
business
The tax law does not define a “trade or business” but for it to be a
trade or business, an activity must have a profit motive and some
kind of economic activity
So what defines a profit motive –
The IRS uses a list of things to consider whether an activity is for
profit
- all of which must be considered together:
What is the possibility of profit?
Does the taxpayer depend on the activity as a source of
income?
Is the activity carried out in a businesslike manner?
How much time and effort does the taxpayer spend on the
activity?
Are losses from the activity the result of sources beyond the
taxpayer’s control?
Has the taxpayer changed business methods in attempts to
improve profitability?
What is the taxpayer’s expertise in the field?
What success has the taxpayer had in similar operations?
Will there be a possibility of profit from asset appreciation?
Presumption of profit motive: If an activity shows a profit for any 3
or more years during a period of 5 consecutive years then the IRS
will presume that a taxpayer has a profit motive
Note: if the activity involves breeding, training, showing or racing
horses, the period is 2 out of 7 years
Of course, any activity that is reported on a tax return as a business
but has had year after year of losses and no gains will probably
eventually come under scrutiny by the IRS
Tax Treatment of Hobbies - if an activity is deemed to be a hobby,
then “hobby loss” rules – apply. Under these rules, any income
from the hobby is reported on the face of the tax return, and the
expenses are only deductible if a taxpayer itemizes their
deductions on Schedule A. In addition, hobby expenses are limited
by category as follows:
Category 1: In this category expenses are reported on the
appropriate lines of Schedule A as they would be if no hobby
activity existed and includes deductions for home mortgage
interest, taxes, and casualty losses
Category 2: Most expenses that a business would incur, such as
those for advertising, insurance premiums, interest, utilities,
wages, etc., belong in this category. They don’t result in an
adjustment to the basis of property but only to the extent that
gross income from the activity is greater than the deductions
under Cat 1
Category 3: Depreciation and amortization belong in this last
category. These deductions are allowed, but only to the extent
that the gross income from the activity exceeds the deductions
under categories 1 & 2 above. In other words category 3 is not
intended to create a loss as a net result
Note: Taxpayers have to claim the amounts in categories (2) and (3)
(as miscellaneous deductions on Schedule A) which are subject to
the 2% AGI reduction; as a result, they are not deductible for AMT
2. Call Cliff at (949) 813-1349