Can My Hobby Be A Business?

By Steven A. Leahy

 

Do you use deductions for a side business to reduce your tax liability?  The IRS makes a distinction between business activity and activity that is a hobby, therefore not a business activity.    If the activity qualifies as a business, the taxpayer can deduct ordinary and necessary expenses used to conduct that business. However, if the activity is determined to be a hobby, losses from the activity cannot be used to offset other income.

Most side businesses are undertaken because the taxpayer enjoys the activity – being allowed to deduct the expenses for that activity is just a bonus.  The best way to qualify your hobby as a business is to earn a profit.  Generally, if an activity is undertaken with a reasonable expectation of earning a profit, it qualifies as a business.  The rule of thumb is – if the activity makes a profit during at least three of the last five years, including the current year, the activity is business activity.

This rule is not hard and fast.  For example, a documentary filmmaker – who lost money six years in a row, was permitted to deduct hundreds of thousands of dollars in film making expenses against her income as an attorney.  Tax Judge Kroupa recognized that some industries have longer start up periods than others, and the rule of thumb doesn’t account for those industries.

If you haven’t made a profit, here are some things you can do to demonstrate your intentions that this activity is for profit, rather than just for fun:

First, offer evidence that you expect to make a profit in the future.  As in the documentary filmmaker case, losses as a result of a slow start-up may be deductible if you can show that a profit in the future is possible.

Next, expend time and effort into the activity.  The more time and effort you demonstrate, the more likely the IRS will agree that the activity is a business.  For example, you should document the time you spend on the activity, open a separate bank account, keep accurate records, advertise the business, and comply with local, state and federal business requirements (i.e. permits, licensees, etc.).  All of these efforts demonstrate your intentions to make the activity profitable.

Finally, if the activity is not profitable, work on making it profitable. You can do this by changing the method of operations to attempt to make the activity profitable, seeking help from an expert to learn how to make the activity profitable, demonstrate an expertise in the activity – experts generally command a higher price.

There is a Tax Court case involving a track coach.  The coach lost money for eight years, and the IRS denied his deductions under section 183 of the tax code “activities not entered into for profit.” The Tax Court looked at his attempts to make his activity profitable, including those mentioned in this article, and decided his activities were intended to make a profit.

The best time to present these arguments is at the audit.  However, if a deficiency is assessed, the fight need not be over. So, if you are under audit, or have already had a deficiency assessed based on disallowed expenses for activities not entered into for profit, you should work with a local law firm that will fight the IRS findings on your behalf. Better, you should give me a call – Opem Tax Resolutions & The Law Office of Steven A. Leahy, PC (312) 664-6649.  I want to help! Call NOW to set up your FREE Consultation.

Do I Have to File My Tax Return?

By Steven A. Leahy

Many of my clients are non-filers. Meaning, they haven’t filed a tax return for some years. Non-filers are not the same as tax protesters. Tax protesters do not file tax returns under the mistaken belief that there is not a legal obligation to file a tax return. Many do not understand that failure to file a tax return is a crime, punishable by up to one year in prison for each unfiled return. Other, more serious felony counts may also be charged – tax evasion and tax fraud.

Non-filers are not often prosecuted for failure to file. Tax protesters are routinely prosecuted for failure to file, because of the willful nature of their non-filing. There are at least eight different arguments tax protesters cite as reasons filing a tax return is not required.

1. There is no law requiring you to pay federal income taxes;
2. The Internal Revenue Code is not law;
3. Income tax is voluntary;
4. Wages are not income;
5. First Amendment;
6. Fifth Amendment;
7. Thirteenth Amendment, and;
8. The Sixteenth Amendment.

These eight arguments can be divided into two basic categories – Interpretative arguments and Constitutional arguments. Interpretative agreements relied on by tax protesters interpret the IRS Code, court opinions and the Constitution very narrowly. For example, tax protestors contend that there is nothing in the Code that makes ordinary citizens “liable” for income taxes. It is true, the word “liable” is not used in the IRS Code to describe citizens’ obligations. But the IRS Code does use many other words that mean the same thing – “obligation,” “impose,” “shall pay,” etc.

Another Interpretive argument is that the IRS Code refers to “taxpayers” having an obligation to file tax returns and pay taxes. Tax protesters argue, if a person does not file tax returns or pay taxes, they are not a “taxpayer” and therefore not required to pay taxes. There are many other examples of these interpretative arguments; all have been dismissed as “frivolous” by Courts across the country.

The second category points to Constitutional problems as reasons why tax returns are not mandatory for US Citizens. First Amendment arguments citing religious objections, Fifth Amendment arguments complaining of self-incrimination, Thirteenth Amendment objections to taxes making slaves of citizens, Sixteenth Amendment validity arguments, all have been described as “frivolous” by courts. The Sixteenth Amendment argument is the most common argument. Tax protestors point to variations of the amendment approved by different states, punctuation differences, spelling differences, formatting differences, etc. The time to argue ratification has long since past. ALL Courts recognize the validity of the Sixteenth Amendment.

One very famous case of a tax protester refusing to file tax returns and pay taxes involved Wesley Snipes, a movie actor. Mr. Snipes was recently released from a three year misdemeanor prison term, after being acquitted of felony conspiracy and tax fraud charges and three additional counts of failure to file. He bought into many of the tax protester arguments listed here, and had a team of lawyers working to convince the courts of his position. While he avoided the more serious felony charges, the Court sentenced him to the maximum term available under the misdemeanor statute.

Some of these arguments are interesting. But understand, once charged, a judge will not entertain these arguments in any serious way – and you very well may end up in prison like Wesley Snipes.

So, if you have unfiled returns, you should work with a local law firm that will work to get your late returns filed and avoid jail. You should give me a call – Opem Tax Resolutions & The Law Office of Steven A. Leahy, PC (312) 664-6649. Call NOW to set up your FREE Consultation.

Why Did the IRS Audit Me?

By Steven A. Leahy

Many of our clients have lived through an audit before seeking our help to resolve their IRS problems. The audit will leave them with a balance they are unable to pay. A common question is “Why did the IRS audit me?”

The IRS calls an audit an “Examination of Returns.” The IRS accepts most federal tax returns just as they are filed. Some returns, however, are selected for review. The IRS selects returns for audit by computerized screening, random sample, or by an income document matching program. An examination can take place in several ways. Some audits are handled exclusively by US Mail, in the taxpayer’s home or place of business, at an IRS office or at your representative’s office. The time, place, and manner of the audit are negotiable.

Taxpayers are free to represent themselves, and, if the taxpayers filed a joint return, either spouse, or both, can meet with the IRS. Taxpayers are also free to hire a representative to represent them in an audit. The representative must be a federally authorized practitioner – attorney, certified public accountant, an enrolled agent, an enrolled actuary, or a tax preparer (as long as they prepared the return in questions and signed it as the preparer).

The first audit selection process is computerized screening, and it works on a scoring procedure. The IRS uses a computer program called the Discriminant Inventory Function System (DIF). Exactly how the system scores a return, and the statistical formula used, are closely guarded secrets. DIF assigns a score to each return based on oddities and discrepancies.

For example, if your income or deductions change dramatically from one year to another, the IRS will take notice, and your chances of an audit increase accordingly. Deductions that are too great a percentage of your income may cause an audit. Lots of home office deductions may cause an audit. Not filing your return on time without applying for an extension, or not paying the full tax owed without attaching an Installment Agreement application, will increase your chances of an audit. And finally, tax return errors, mistakes, typos or a sloppy return will increase your DIF score, along with your chances of an audit.

The second selection process is a random drawing. The IRS selects some tax returns randomly. That means, even if you do everything right and zero red flags are raised, you still may be audited. The random process is used as a benchmark to compare the random returns, to those selected by other methods.

Document matching is another way the IRS selects tax returns for audits. The IRS will match a tax return to information they gather from others – vendors, businesses, related entities, and other sources. The IRS will match your reported income with 1099, W-2 and other third-party documents. If there are discrepancies, the tax return will be audited.

Finally, other sources are used to assume non-compliance or inaccurate filings. For example, we had a group of individuals seeking our help from the same large company. It turns out that they all used the same tax preparer. The tax preparer used questionable tactics to increase their clients’ refunds. Large tax return refunds worked to grow the tax preparer’s business very quickly, but also raised red flags with the IRS. When the IRS caught on, they audited every tax return that business prepared. The IRS ultimately closed the tax preparer’s business.

Generally, the IRS has three years from the due date to audit a return. That explains why the IRS will usually conduct an audit for three consecutive years, rather than just one. There are exceptions to the three year rule. For example, if you underreport your income by more than twenty-five percent, the IRS has six years to audit. And, if a taxpayer files a fraudulent or false return, there isn’t a time limit on an audit.

So, if you are facing an IRS audit, or have already been audited, you should work with a local law firm that will work to get you through the audit process and collections in the best way possible. You should give me a call – Opem Tax Resolutions & The Law Office of Steven A. Leahy, PC (312) 664-6649. Call NOW to set up your FREE Consultation.