Is a checkbook enough? - Documenting losses on a part-time business
What
do Tupperware, Shaklee and Mary Kay have in common? Their products aren't
similar, but they all do business the same way and depend on the average
consumer to sell their products. Based on their bottom lines, these companies
and others like them have been very successful. Add to these lines of business
the doctor who also raises cattle or the professional who makes jewelry
in his or her spare time and the similarities become harder to find. So
what might these dissimilar businesses have in common? At tax time, their
proprietors need to prove they are.well..businesses. In some cases, the
stakes can be high.
Here's an example: take the professional who earns a salary of $500,000 but spends $100,000 on a cattle operation. He or she might have sold a few head of cattle this year but more typically took a loss on the operations - and the IRS does not like to see this on a taxpayer's return.
Then there's the carpenter who works for a construction company all day and goes home to knock out a few objects d'art before bedtime. Some might say this is a hobby, but in his mind he's trying to get a second career going and hoping someday to become another Picasso.
Finally, there are those who get into sales of Tupperware and other products because they like the product and want to earn the starter kit. That might be all they want to do, but they are still selling a product and turning a profit, albeit a small one.
What's wrong with taking a deduction for the losses these self-starters might incur in the pursuit of their dreams? A lot of people might answer nothing. Unfortunately, the Internal Revenue Code is not necessarily formulated that way. If you're in a similar situation, how you can protect yourself in the event of an audit?
The Rules
Internal Revenue Code Section 183 limits the amount that can be deducted when you are not engaged in an activity for profit. Basically, the deductions are limited to the gross income from the activity. To illustrate this, let's say you raise cattle in your spare time and you incur $100,000 in expenses, including the cost of the cattle in the activity. Assuming your sales for the year total $50,000, you show a loss of $50,000. If the IRS can show you did not intend to turn a profit on the cattle operation, then your deductions against income are limited to $50,000 - not very favorable to your tax bill. If you can prove the operation is meant to turn a profit, you might be able to deduct the full $100,000 and offset other income by the net $50,000 loss. How will you do that?
You can argue until the cows come home that you planned to make money, but the IRS will look use a nine-factor test to determine whether the business is engaged in for profit. Here is what you will do.
First, you will operate your cattle operation in a businesslike manner. That means keeping adequate records and separating your personal funds from the business funds. It's not enough to rely on cancelled checks. In one case, the Tax Court determined that a horse breeder did keep adequate records because he meticulously recorded the horses' pedigrees and all of the pertinent expenses and income in a farm record book. On the other hand, the only financial information supporting his deductions were cancelled checks, so the court determined the operation was not run in a businesslike manner.
Second, you will show that you have the expertise to operate a cattle farm profitably. If you don't have the expertise, find someone who does. In one case, a taxpayer was born and raised on a farm. In denying his loss deduction, the court said the taxpayer did not know how to make a profit from his current farm undertakings and, while he did seek advice about farm concerns, he did not seek advice on how to make a profit at farming.
Third, you will show that you spend substantial time and effort on the cattle operations and that your efforts were designed to enable your operations to make a profit. It is not necessary to spend 40 hours a week on the operation, but you will need to show involvement in the business. Hiring a full-time ranch supervisor to act in your stead would fill the bill. This is very much what the IRS likes to call a facts and circumstances situation.
The term profit does not necessarily mean that you make money on the activity itself. If, for example, you reasonably expect the investments made in the cattle operation to enhance the value of your land, this could be enough to prove a profit motive. You will need to show that you expect the gain from appreciation in the asset's value to exceed the annual losses, thereby realizing a net gain over the life of your project.
Your past track record in showing a profit from other activities, whether similar or dissimilar, will also be a factor in determining if you can reasonably be expected to profit from your present operations. In one case, the IRS disallowed the expenses a lawyer incurred in a failed attempt to facilitate the sale of artwork. The court looked to past transactions where the lawyer served in similar capacities and did, indeed, realize a profit. The irony is that those successful transactions were the cause of the IRS investigation in the first place. The court ruled the taxpayer was engaged in the activity with a profit motive.
Your intent to create a profit from your cattle operation can also be shown by the business' history of profit and loss. In the early years of a start-up venture, losses are to be expected. If your cattle operation turns a profit in three of the last five consecutive years - ending with the tax year in question - the business is considered to be operated with a profit motive (unless otherwise proven by the IRS).
The amount of an occasional profit in relation to losses is also indicative of a profit motive. For example, if you typically incur small losses but occasionally earn significant profits on the sale of cattle to offset those losses, this could indicate that you are engaged in an activity designed to turn a profit.
Your financial status also might be considered relevant to your motives for entering into the cattle farming business. Generally, the less you have, the easier it is to prove you are running a business to produce income for you and your family's support.
Finally, is there an element of personal or recreational enjoyment involved? Not the incidental kind that comes from a job well done, but real enjoyment? For example, are you taking your personal boat out for deep sea fishing excursions? Such a situation arose recently and the court found in favor of the IRS.
The Lessons
It is not uncommon for taxpayers to think their business must turn a profit three out of five years to escape hobby loss treatment. The truth is, however, that individual facts and circumstances must be examined to determine if you are likely to be challenged on deducting your business losses. Keeping a checkbook is not enough to stave off an aggressive IRS agent. Give us a call if you have part-time activities that produce losses and let's find a way to document your actions to prove you are engaged in profit-driven behavior.
Help! I've been robbed! - Protect yourself from identity theft
On February 2, 2000, a young child died. The loss was devastating for his family, but what happened when his parents tried to file their tax return only compounded the tragedy. The Internal Revenue Service disallowed the dependency deduction for the 1-year-old - but it was not the IRS' fault.
At that time, the Bureau of Vital Statistics in the state where they lived allowed searches of death records that included Social Security numbers. Someone had stolen the child's identity; a theft that sent his parents into a nightmare.
Things have changed since 2000, but identity theft is still too frequent an event. While there is no guarantee, there are some practical steps you can take to minimize your chances of becoming a victim.
The single most important thing you can do to protect yourself from identity theft is to protect your Social Security number. A few practical steps you might take include:
Reveal the number
on a need-to-know basis only. Banks, employers and certain businesses might
need the number to open an account or extend credit. If you are asked for
your Social Security number by a business, do not provide it until you get
the following questions answered:
Why is your number needed? What will the business do with your number? How will the business keep your number from being stolen and how will it be protected from unauthorized use? What will happen if you don't provide your Social Security number?
Do not carry your
Social Security card or Social Security number in your wallet or purse (in
case it is stolen).
Ask your state not
to include your Social Security number on your driver's license.
Under no circumstances
should you provide your Social Security number over the telephone to anyone
you do not know.
The second step in protecting your identity is similar to protecting your Social Security card. Do not give a credit card number or bank account number over the phone to anyone you do not know.
Third, be careful with your trash. Thieves will go through it for credit card (and other credit) offers. These already have your Social Security number attached to them by the offering company, even if you don't see it on the application. In addition, bank statements, credit card receipts, insurance billings and other trash could include your Social Security or credit card number. Shred this information before throwing it out.
Be careful when surfing the Internet. Thieves have all sorts of ingenious methods to glean information from your Internet wanderings. For practical protection tips, go to www.OnGuardOnline.gov.
Use secure passwords. At a minimum, use a combination of uppercase and lowercase letters, along with numbers. If special characters are allowed, include those in the password. Don't use passwords that include your name or other personal information.
Do not open or respond to emails from people or companies that you do not know. Under no circumstances should you verify an account number or other information even from a seemingly legitimate source. Your bank and other credit providers will not ask you for account verification or other personal information by email.
Keep tabs of your purse or wallet. If you are shopping, don't leave your purse in the shopping cart and go to another aisle to get something you forgot. Always keep it in sight.
If your state allows a credit freeze, take advantage of it. A credit freeze restricts access to your credit records unless you temporarily lift the freeze. This prevents thieves from opening an unauthorized credit account since the potential creditor won't be able to access your information. This will not affect your credit score.
Keep a list of all credit card numbers and accounts you have in case you need to call and cancel them.
Review your credit report often to determine if there are any unauthorized inquiries.
While there are a number of other tactics you can use to protect yourself, let's turn to minimizing losses. If your personal information has been compromised or your wallet or purse is stolen:
1. Contact credit agencies such as Equifax and place a fraud alert on your account. Review your credit records.
2. Contact all banks and credit card issuers with whom you have an account and inform them of the theft. Most likely, you will need to close the accounts and open new ones.
3. File a police report.
There is no guarantee that you can avoid becoming a victim of identity theft. However, following a few simple steps will help minimize your chances of being victimized and help you recover if your information is compromised.
Technology: The iPad.decisions, decisions, decisions
If you are as technologically dependent as most bosses and business owners today, you've been watching the launch of the iPad and wondering whether to get one. Here are some thoughts to mull over if you are contemplating buying a tablet.
What does it offer? Do you need one?
First of all, let's consider what the iPad is and what key features it offers.
What is it? First
of all, the iPad is hard to classify. It's not a computer and lacks some
of the features and capabilities we usually expect from a computer. It will
not replace your notebook, but it is more advanced than a smart phone or
personal digital device. Individuals will need to look at key features to
see if this new hybrid fits their current pattern of Internet usage, and
if it is a good investment.
Who is most likely
to make good use of it? People who love e-reading and Internet-based entertainment.
The iPad is perhaps most appealing to people who like to read books online,
e-readers and those who browse the Web frequently, watch movies or play
games on their current Internet-enabled device. Its larger screen, Wi-Fi
capabilities and, in the case of the higher-end models, 3-G Internet connectivity
are big pluses for many users. The battery is designed to last 10 hours
even with lots of usage.
What about costs
for hardware and subscriptions? Models start at around $500, but you'll
need to pay around $800 for 3G capability and 64GB of storage. Is that pricey
for what the iPad provides? Perhaps. Subscription rates for 3G capability
with an unlimited data plan that will provide almost constant access to
the Internet go for a reasonable $30 a month. Accessories are available
(purchased separately). They include a docking capability that comes with
an external keyboard.
What are its limitations?
The iPad doesn't offer a USB port, an optical disc drive, a keyboard (unless
you purchase the keyboard accessory package) or a mouse.
What about applications/software?
Your software options are to be found in the iPhone App store. The iPad
doesn't allow users to open multiple apps simultaneously, so if this is
an important feature to you, it probably won't suit you. The iPad is compatible
with the iPhone operating system but not the MAC operating system.
The iPad has competition. Rival tablets all retail for about the same as the iPad base model, and each one offers features that the iPad and the others don't have. Here are some of them:
JooJoo is aimed at
Web surfers and has shortcuts to Twitter and Facebook. It has a webcam and
is designed to provide high-quality streaming HD video. Its battery life
is about half that of the iPad.
Entourage Edge runs
on Google Android and has a camera and two screens, one for e-readers and
one for Web use. Its batteries last 16 hours in e-reading mode and six hours
for color use.
One other product, The Notion Ink Adam, is slated for launch in June. It will offer an HDMI port, a memory card slot and a camera.
Determining if the iPad is a useful addition to your technology tool kit is something that each of us has to decide for ourselves. There will always be early adopters who want to try new technology first, but there is a larger contingent that patiently waits for more feedback from the first users, and for prices to drop.
Questions?
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