Who Claims the Kids? You or Your Ex-Spouse?

If you are a divorced or separated parent with children, a commonly encountered but often-misunderstood issue is who claims the kids for tax purposes. This is sometimes a hotly disputed issue between parents; however, tax law includes some very specific but complicated rules about who profits from the child-related tax benefits. At issue are a number of benefits, including the children’s dependency tax exemption, child tax credit, child care credit, higher-education tuition credit, earned income tax credit, and in some cases even filing status.

This is actually one of the most complicated areas of tax law, and serious mistakes can be made by taxpayers preparing their own returns or inexperienced tax preparers, especially if the parents are not communicating well. Where parents will cooperate with each other, they often can work out the best tax result overall, even though it may not be the best for them individually, and compensate for it in other ways.

Where a family court awards physical custody of a child to one of the parents, tax law is very specific in awarding that child’s dependency to the parent with physical custody, regardless of the amount of child support provided by the other parent. However, the custodial parent may release the dependency (exemption) to the non-custodial parent by completing the appropriate IRS form.

CAUTION – The decision to relinquish the dependency should not be taken lightly, as it impacts a number of tax benefits.

On the other hand, if the family court awards joint physical custody, only one of the parents may claim the child as a dependent for tax purposes. If the parents cannot agree between themselves as to who will claim the child and the child is actually claimed by both, the IRS tiebreaker rules will apply. Per the tiebreaker rules, the child is treated as a dependent of the parent with whom the child resided for the greater number of nights during the tax year, or if the child resides with both parents for the same amount of time during the tax year, the parent with the higher adjusted gross income claims the child as a dependent.

Child’s Exemption – The parent who claims the child as a dependent is entitled to the child’s tax exemption – which is actually a deduction from income of $4,050 in 2016. However, the exemption begins to phase out for higher-income taxpayers with an AGI of $259,400 for single taxpayers, $285,350 for those qualifying for head of household filing status and $311,300 for married taxpayers filing jointly.

Head of Household Filing Status — An unmarried parent can claim the more favorable head of household, rather than single, filing status if the parent is the custodial parent and pays more than one-half of the cost of maintaining as his or her home a household which is the principal place of abode for more than one-half the year for that child. This is true even when the child’s dependency (and therefore the $4,050 exemption deduction) is released to the non-custodial parent.

Tuition Credit — If the child qualifies for either the American Opportunity or the Lifetime Learning higher-education tax credit, the credit goes to whoever claims the child’s exemption. Credits are significant tax benefits because they reduce the amount of tax dollar-for-dollar, while deductions reduce income to arrive at taxable income that is then taxed according to the individual’s tax bracket. For instance, the American Opportunity Tax Credit (AOTC) provides a tax credit of up to $2,500, 40% of which is refundable. However, both education credits phase out for higher-income taxpayers. For instance, the AOTC phases out between $65,000 and $80,000 for unmarried taxpayers and $130,000 and $160,000 for married taxpayers.

Child Care Credit — A nonrefundable tax credit is available to the custodial parent for the care of the child while the parent is gainfully employed or seeking employment. To qualify for this credit, the child must be under the age of 13 and be a dependent of the parent. However, a special rule for divorced or separated parents provides that where the custodial parent releases the child’s exemption to the non-custodial parent, the custodial parent would still qualify to claim the childcare credit, and it cannot be claimed by the noncustodial parent.

Child Tax Credit — A credit of $1,000 is allowed for a child under the age of 17. That credit goes to the parent claiming the child as a dependent. However, this credit phases out for higher-income parents, beginning at $75,000 for unmarried parents and $110,000 for married parents filing jointly.

Affordable Care Act — Parents must keep in mind that where the child does not have medical insurance during periods of the year, the parent claiming the child as a dependent (claims the $4,050 exemption) is the one responsible for any applicable penalties when the child does not have health insurance coverage.

Earned Income Tax Credit (EITC) — Lower-income parents with earned income (wages or self-employment income) may qualify for the EITC. This credit is based on the number of children (under age 19 or a full-time student under age 24) the custodial parent has, up to a maximum of three children. Releasing the dependency exemption to the noncustodial parent will not disqualify the custodial parent from using the children to qualify for the EITC. In fact, the noncustodial parent is prohibited from claiming the EITC based on the child or children whose exemption has been released by the custodial parent.

As you can see, there are some complex rules that apply to the tax benefits provided by children of divorced parents. It is highly recommended that you consult this office for the preparation of your return. If you are the custodial parent you should also consult with this office before making the decision to release a child’s exemption.

Cutting the IRS Out of Your Gifts

If you are financially well off, you may want to gift money or property to family members or others you care about. There are some gift tax issues you should be aware of so that you can avoid gift tax issues. Oh yes, the government even taxes gifts if they are large enough, so it is best to know the rules; otherwise you may end up making a gift of taxes to the IRS.

The gift tax rules provide two exclusions from gift tax, the annual exclusion and the lifetime exclusion:

Annual Exclusion — The annual exclusion is periodically inflation adjusted and is currently $14,000 per individual. Thus you can give $14,000 a year to as many individuals as you wish without any gift tax or gift tax return filing requirements.

Lifetime Exclusion — On top of the annual exclusion, there is a lifetime exclusion that is linked to the estate tax exemption, which is also inflation adjusted, and for 2016 is $5.45 Million. Thus, in addition to the $14,000 annual per donee exclusion, there is a $5.45 Million exclusion that applies to the aggregate of all gifts in excess of the $14,000 per year per donee gifts.

There are complications to utilizing the lifetime exclusion. You must file a gift tax return to claim the lifetime exclusion, and the amounts of the lifetime exclusion used as an exclusion from gift tax will be tracked on any gift tax return(s) filed and will reduce the estate tax exemption. So for example, if in 2016 you make a gift of $3,014,000 to your child, and you haven’t made gifts in the past that exceeded the annual per donee gift tax exclusion, you will pay no gift tax, but you will have reduced your remaining lifetime exclusion to $2.45 Million. If you make more large gifts in the future that use up your remaining lifetime exclusion, not only will you then be subject to gift tax on the excess gifts, but at your passing, and assuming the value of your estate is large enough to be subject to estate tax, you will have no estate tax exclusion left to offset the estate’s value, so it will all be subject to estate tax.
CAUTION
The estate tax rates and the lifetime exclusion have long been a political football. They date back to 2006, when the lifetime exclusion was $2 Million. Congress can change the current $5.45 Million exclusion at any time. In fact, Democratic presidential candidate Hillary Clinton has proposed reducing the exclusion to $3 Million and raising the top estate tax rate from 40% to 45%. She would also disconnect the gift and estate tax exclusions and limit the lifetime gift exclusion to $1 Million.

Special Tuition/Medical Exclusion – In addition to the current $14,000 annual exclusion, a donor may make gifts that are totally excluded from the gift tax in the following circumstances:

  • Payments made directly to an educational institution for tuition. This includes college and private primary education. It does not include books or room and board.
  • Payments made directly to any person or entity providing medical care for the donee.

In both cases, it is critical that the payments be made directly to the educational institution or health care provider. Reimbursement paid to the donee will not qualify. The tuition/medical exclusion is often overlooked, but these expenses can be quite significant. Parents and grandparents interested in estate reduction should strongly consider these gifts.

Gift Splitting — A husband and wife can each make annual exclusion gifts, thereby increasing the exclusion from the current $14,000 to $28,000 per year per couple. However, only one of the spouses may be in a financial position to make the gifts. Spouses may elect on the gift tax return to treat a gift made by one spouse as being made by both spouses. Gift splitting can be used for annual exclusion gifts, lifetime exclusion gifts, and gifts above the lifetime exclusions.

Example — Gift Splitting —John and Jane are married and have two children. In a year when the annual exclusion limit is $14,000, they would like to exclude $56,000 ($14,000 x 2 donors x 2 donees) in gifts. Jane received a large inheritance some years back; John has only a modest estate. Jane gives the children $28,000 each. Then the couple elects to gift split so that the $28,000 gift is treated as given one-half by Jane and one-half by John (or $14,000 each). The gifts all qualify for the annual exclusion. Even if both spouses have sufficient resources to make gifts, gift splitting is useful when the husband and wife have different estate planning goals.

For residents of community property states, if community property is given, gift splitting is not necessary. Regardless of who holds the property’s title, or who “makes” the gift, the property is owned one-half by each and is therefore given one-half by each.

Gifts of Property — Gifts of property have some of their own circumstances to consider. For instance, where gifts are made of appreciated property such as stocks or real estate, although the donor’s gift is considered at the fair market value (FMV) for purposes of valuing the gift, the beneficiary of the gift assumes the donor’s basis. As a result, the beneficiary of the gift is assuming any taxable gain the donor would have had if he or she had sold the property instead of gifting it and will have to include as income that gain when and if the gifted property is later sold.

Although the FMV of traded stocks is readily available, the same is not true of most other types of property, in which case a qualified appraisal will be needed to determine the value as of the date of the gift.

Finally, keep in mind that a beneficiary inherits property at its FMV at the date of the decedent’s death as opposed to assuming the decedent’s basis, as happens in the case of a gift.

If you are contemplating gifting money or property to an individual, it may be appropriate to consult this office in advance to minimize the impact on estate taxes and help with any gift tax filings that may be required.

Don’t Be Left Holding the Tax Bag

If you use independent contractors in your business and pay them $600 or more during the calendar year, you are required to issue them a 1099-MISC after the close of the year. If you fail to do so, and your (if you operate as a Schedule C sole proprietor) or your business’s income tax return is subsequently audited, you could lose the deduction for those payments and end up paying taxes on that income yourself, not to mention potential penalties.

A big tax trap for businesses is the $600 reporting threshold. Say your business uses the services of an independent contractor early in the year at a cost below the $600 threshold, and you don’t bother to obtain the necessary reporting information from the contractor. If you use the contractor’s services again later in the year and the combined total you’ve paid him or her exceeds the reporting threshold, you won’t have the required reporting information.

Sorry to say, you may find it difficult to obtain that information after the fact, as not all self-employed individuals report all their income, and contractors may not be willing to give you their tax ID information once they’ve completed the work and gotten your payment for their services. So, it is good practice to collect that information upfront before engaging the contractor regardless of the amount.

The IRS provides Form W-9 — Request for Taxpayer Identification Number and Certification — as a means for you to obtain the data required from your vendors in order to file the required 1099-MISC forms after the close of the year. A completed W-9 also provides you with verification that you complied with the law should the vendor provide you with incorrect information.

In addition, there are substantial penalties if you fail to file a correct 1099-MISC by the due date and you cannot show reasonable cause for not filing. Generally, for 1099 forms due in 2017, the penalty is $50 per 1099-MISC for not filing by the due date. The penalty increases to $100 if the form is not filed within 30 days of the due date and $260 after August 1, 2017. The maximum penalty for small businesses is $532,000, so you can see this is not a reporting requirement to be taken lightly.

Oh, and by the way, the due date for filing 2016 Forms 1099-MISC with the IRS is January 31, 2017, when you are reporting nonemployee compensation (box 7 of the form), which includes the income paid to independent contractors. This due date is a month (two months if you’ve been filing your 1099s electronically) earlier than it has been in the past. So now both the government’s copy and the one you provide the contractor are due by the same date.

If you have questions related to your 1099-MISC reporting requirements or need assistance filing the required forms after the end of the year, please give this office a call.

Taking Advantage of Back-Door Roth IRAs

If you are a high-income taxpayer who cannot contribute to a Roth IRA due to income limitations, there is a work-around that will allow you to fund a Roth IRA.

High-income taxpayers are limited in the annual amount they can contribute to a Roth IRA. In 2016, the allowable contribution phases out for joint-filing taxpayers with an AGI between $184,000 and $194,000 (or an AGI between $0 and $9,999 for married taxpayers filing separately). For unmarried taxpayers, the phaseout is between $117,000 and $132,000. Once the upper end of the range is reached, no contribution is allowed for the year.

However, those AGI limitations can be circumvented by what is frequently referred to as a back-door Roth IRA. Here’s how it works:

  1. First, you contribute to a traditional IRA. For higher-income taxpayers who participate in an employer-sponsored retirement plan, a traditional IRA is allowed but is not deductible. Even if all or some portion is deductible, the contribution can be designated as not deductible.
  2. Then, since the law allows an individual to convert a traditional IRA to a Roth IRA without any income limitations, you now convert the non-deductible Traditional IRA to a Roth IRA. Since the Traditional IRA was non-deductible, the only tax related to the conversion would be on any appreciation in value of the Traditional IRA before the conversion is completed.

Potential Pitfall — There is a potential pitfall to the back-door Roth IRA that is often overlooked, that could result in an unexpected taxable event upon conversion. For distribution or conversion purposes, all of your IRAs (except Roth IRAs) are considered as one account and any distribution or converted amounts are deemed taken ratably from the deductible and non-deductible portions of the traditional IRA, and the portion that comes from the deductible contributions would be taxable.

This may or not may affect your decision to use the back-door method but does need to be considered prior to making the conversion.

There is a possible, although complicated, solution. Taxpayers are allowed to roll over or make a trustee-to-trustee transfer of IRA funds into employer qualified plans if the employer’s plan permits. When permitted, such rollovers or transfers are limited to the taxable portion of the IRA account, leaving behind the non-taxable contributions, which can then be converted to a Roth IRA without any taxability.

Please call this office if you need assistance with your Roth IRA strategies or in planning traditional-to-Roth IRA conversions.

Customizing QuickBooks Online Forms

Make a good impression on your customers by sending them well-designed sales forms. QuickBooks Online helps you create them.

Your company’s “brand” can be composed of many things (and has many definitions), but it’s really about what pops into your customers’ minds when they think of you. Key components include your logo, your color scheme, and any other identifying visual element that people associate with your business.

A good way to reinforce this image is by making sure that a unifying graphic theme runs through every piece of print or web-based customer content you create, like your website, brochures, blog, and ebooks. Your brand should also be visible on all sales forms you dispatch, like invoices and receipts.

QuickBooks Online comes with its own default sales form style; this is the layout and content that will automatically display when you start a new transaction. You can easily change this and have it apply to all transactions.

Your logo is an important element of your company’s brand. QuickBooks Online lets you include it on sales forms.

Here’s how it works. Click on the gear icon in the upper right of the screen, next to your company name. Select Custom Form Styles to open the table of existing styles. There should be one labeled Standard, though there may be another labeled Classic. You can make either the default by clicking Make Default or Remove as default using the down arrows and links under ACTION at the far right of each row.

Click the Edit link for the default style. This screen contains many of QuickBooks Online’s customization tools. The Style tab in the left vertical toolbar is automatically highlighted. In the column to its right, click through the five design options available and leave the desired one selected. Then click the plus (+) sign in the upper right of the screen. Browse for your logo file when the directory opens and double-click on it to add it to the top of your sales forms. Choose the color scheme you want by clicking in the correct box displayed below.

When you’re done there, click on the Appearance tab to specify your logo’s placement and change any other settings. Content Critical

You can decide which fields should and shouldn’t appear on your sales forms by checking and unchecking boxes.

You won’t necessarily need to make every data field available on your sales forms. But you want to include every field you might possibly need without displaying extraneous content areas. QuickBooks Online lets you turn fields on and off and change their labels easily by checking and unchecking boxes.

Click the Header tab on the left to start this process. Among your options here are:

  • Form names. Do you want invoices to say “Invoice,” for example? Do you want to use form numbers and allow custom transaction numbers?
  • Company. How much of your company’s contact information should appear?
  • Customer. Do you want fields for Terms, Due date, etc?
  • Custom. Do you need to define custom fields?

You’ll see more options when you click on the Activity Table tab in the left vertical pane (see image above). Not only can you choose what content appears and how its labels read, but you can also indicate what percentage of that line each entry should occupy. Under WIDTH%, click on the plus (+) and minus (-) buttons to the right of each number to size it (your numbers, of course, should total 100).

Warning: Many of the decisions you have to make when customizing sales forms are simple. Others take some consideration, like custom fields and the handling of billable time. We can help you with these.

Click on the final tab in the left navigation pane, Footer, to add or edit text that should be displayed at the bottom of your sales forms. Click Save in the lower right when you’re done.

Some settings may need to be tweaked in Account and Settings.

Note: As you’re browsing through the content options available as described above, you may find that a field appears to be missing or needs a default setting changed. If this occurs, click on the gear icon in the upper right of the main screen, then on Your Company | Account and Settings. Click on the Sales tab in the left vertical pane to get to Sales form content.

Consistent, well-designed sales forms will help promote your brand and present a polished, professional image to your customers.

14 Interviews with Some of the Most Influential Entrepreneurs of our Time

As a business owner, sometimes it feels like the weight of the world is on your shoulders. It is your money and time on the line. It is your business decisions and the risks you take on that will help define your future. We compiled a list of interviews of some of the most successful thought leaders that might help shed light on the struggles all entrepreneurs go through. Sometimes it just makes you feel better when you hear how others overcame the same struggles you face and made it big.

Time to get inspired.

1) Entrepreneur: Elon Musk – CEO of Tesla Motors and SpaceX

Why you should listen:
Elon Musk is one of the biggest disruptors of our time. His ambitions are forward-thinking and, if executed, will redefine many aspects of our lives. This interview goes into some background and describes his passion for the way he does things.

Quotable: “…a lot of friends of mine tried to talk me out of starting a rocket company because they thought it was crazy.”

2) Entrepreneur: Scott Cook – Founder and Chairman of the Executive Committee, Intuit

Why you should listen:
Scott Cook and his company revolutionized accounting for small-business owners. He talks about how Intuit started and grew into such an influential company.

Quotable: “No VC said yes.”

3) Entrepreneur: Drew Houston – CEO and Founder of Dropbox

Why you should listen:
Dropbox is now used by over 300 million people worldwide. Drew goes over how he started writing code when he was 5 and landed his first job at age 14.

Quotable: “Reading about business is probably the most important thing that’s prepared me for running Dropbox.”

4) Entrepreneur: Oprah Winfrey – The Secret of My Success

Why you should listen:
Oprah Winfrey discusses the qualities that made her a top-rated talk-show host and the importance of spirituality.

Quotable: “I work at staying awake.”

5) Entrepreneur: John Paul DeJoria’s Top 10 Rules For Success

Why you should listen:
John Paul DeJoria is a self-made businessman who overcame homelessness to become a multi-billionaire. His 10 rules of success are a must for any business owner.

Quotable: “…reorder business, you are never selling, you are trying to get it in someone’s hands, whether it is a service or a product, knowing that it is so darn good they are going to want to order again or tell a friend about it…”

6) Entrepreneurs: Steve Jobs and Bill Gates – Together Sit Down

Why you should listen:
Two of the brightest technology minds on the planet took the stage together for a rare look into their rivalry and mutual respect.Quotable: Jobs: “Building a company is really hard, and it requires your greatest persuasive abilities…” Gates: “We build the products we want to use ourselves.”

7) Entrepreneur: Larry Ellison, Oracle: Top 10 Rules for Success

Why you should listen:
Larry is one of the most competitive entrepreneurs the planet has ever seen. His accomplishments include running Oracle and his other hobbies, like America’s Cup.

Quotable: “Translating a good idea into a great product is unbelievably hard.”

8) Entrepreneur: Tony Robbins: TED Talks Why We Do What We Do

Why you should listen:
Tony has helped guide millions to learn their “why” in life. You can’t miss the high-five to Al Gore during this TED Talks presentation.Quotable: “Decision is the ultimate power.”

9) Entrepreneur: Richard Branson 

Why you should listen:
Richard Branson talks to TED’s Chris Anderson about the ups and the downs of his career, from his multibillionaire success to his multiple near-death experiences — and reveals some of his (very surprising) motivations.

Quotable: “All you have in life is your reputation. And it is a very small world.”

10) Entrepreneur: Jeff Bezos – Amazon

Why you should listen:
Amazon CEO Jeff Bezos sat down with Henry Blodget at Business Insider’s Ignition 2014 for an in-depth interview on a variety of topics. Jeff talks about his philosophy and how he deals with “mistakes.”Quotable: “I have made billions of dollars of failures at Amazon.com.”

11) Entrepreneur: Sheryl Sandberg Lean in: A Discussion on Leadership

Why you should listen:
Sheryl Sandberg is the COO of Facebook and addresses an audience at the Pentagon to talk over leadership and gender bias.Quotable: “That little girl is not bossy. That little girl has executive leadership skills.”

12) Entrepreneur: Arianna Huffington – On Entrepreneurship

Why you should listen:
Arianne Huffington and Joshua Kushner are exploring what it takes to be an entrepreneur from both ends – investment and entrepreneurship. Being both investor (Thrive Capital) and entrepreneur (Oscar), Joshua is the ideal team member for this ping-pong session on the ying-yang of start-ups.Quotable: “We all need time to disconnect from our important jobs and our innovations and our startup and reconnect with ourselves.”

13) Entrepreneurs: Victoria Ransom, CEO Wildfire, Alexa von Tobel, CEO, LearnVest and Shunee Yee, Founder and CEO, CSOFT International

Why you should listen:
A talk with some of the best and brightest female founders and entrepreneurs.

Quotable: “I just wanted to get out of bed every morning and feel like I was making a difference.”

14) 50 Entrepreneurs share priceless advice in short clipsWhy you should listen:
Over 50 of the best of the best entrepreneurs share their thoughts in short bursts in this inspiring ensemble of short clips.

Quotable: “By why, I mean what is your purpose, what is your cause, your belief, why does your organization exist.”

Grandchild IRA Gift Idea

If you have a young grandchild, we have a gift suggestion for you that can provide a lasting legacy between you and your grandchild.

Many teens and young adults work during the summer months, and the wages they earn qualify them to make a contribution to either a traditional or Roth IRA. However, most young people are reluctant to fund an IRA account with their hard-earned summer income, and few are concerned with retirement, which is probably the last thing on their minds at their age.

This is incentive for a grandparent, or anyone for that matter, to gift the child money to fund an IRA. The maximum that can be contributed to an IRA is the lesser of the child’s earned income or $5,500 (the 2016 limit for an individual under age 50). Although that is the maximum amount, a lesser amount can be contributed.

If you take our suggestion, you will also need to decide whether the IRA should be a traditional or Roth IRA. Traditional IRA contributions are tax deductible, but the withdrawals at retirement are taxable. Most youngsters working during the summer months or part time year-round may not earn enough to even have any taxable income, and even if they do, the income is likely to be in the lowest tax brackets, so an IRA deduction would provide little if any tax benefit.

On the other hand, a ROTH contribution is not tax deductible and the distributions, including earnings, are tax-free at retirement, making it the best option in most cases.

Accomplishing this gifting will require cooperation from the child, as he or she will need to actually set up the IRA account so you can fund it. This may entail getting the child’s parents involved as well. What you don’t want to do is just make a check out to the child, who could then cash the check without actually putting the money into the IRA.

Your contribution to the IRA would be treated as a gift for gift tax purposes, but since the contribution amount would be below the annual $14,000 (2016) gifting exemption, it would not be subject to any gift tax reporting unless additional reportable gifts were given to the child during the year.

Unfortunately, you won’t get any benefit on your own income tax return for your generosity, but knowing you’ve made a long-term investment in your grandchild’s future will probably be benefit enough. If you need assistance determining the contribution amount or the type of IRA, please give this office a call.

Hobbies and Income Tax

Millions of U.S. taxpayers engage in hobbies such as collecting stamps or coins, refurbishing old cars, making crafts, painting or breeding horses, and the list goes on.

Some hobbies will actually generate income, and some will even evolve into businesses. The tax treatment of hobbies with income is quite different than that of a trade or business, and making the distinction can be rather complicated. The main issue here is that the IRS does not want taxpayers to write off hobby expenses under the guise of trade or businesses expenses.

So, the first question is whether the activity is a hobby, trade or business. The tax law doesn’t really provide a bright-line definition of the term “trade or business,” probably because no single definition will apply in all cases. But certainly, to be considered a trade or business, an activity must be motivated by the taxpayer’s profit motive, even if that motivation is unrealistic. Along with a profit motive, the taxpayer must carry on some kind of economic activity.

Factors to determine profit motive – The IRS uses a series of factors to determine whether an activity is for profit. No one factor is decisive, but all of them must be considered together in making the determination.

(1) Is the activity carried out in a businesslike manner?
(2) How much time and effort does the taxpayer spend on the activity?
(3) Does the taxpayer depend on the activity as a source of income?
(4) Are losses from the activity the result of sources beyond the taxpayer’s control?
(5) Has the taxpayer changed business methods in attempts to improve profitability?
(6) What is the taxpayer’s expertise in the field?
(7) What success has the taxpayer had in similar operations?
(8) What is the possibility of profit?
(9) Will there be a possibility of profit from asset appreciation?

Presumption of profit motive – There is a presumption that a taxpayer has a profit motive if an activity shows a profit for any three or more years during a period of five consecutive years. However, if the activity involves breeding, training, showing or racing horses, the period is two out of seven consecutive years. An activity that is reported on a tax return as a business but has had year after year of losses and no gains is likely to eventually come under scrutiny by the IRS.

Tax Treatment of Hobbies – While trades or businesses can have losses without restriction, if the activity is deemed to be a hobby, then special rules – frequently referred to as “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: This category includes deductions for home mortgage interest, taxes, and casualty losses. They are reported on the appropriate lines of Schedule A as they would be if no hobby activity existed.
  • Category 2: Deductions that don’t result in an adjustment to the basis of property are allowed next, but only to the extent that gross income from the activity is greater than the deductions under Category 1. Most expenses that a business would incur, such as those for advertising, insurance premiums, interest, utilities, wages, etc., belong in this category.
  • Category 3: Business deductions that decrease the basis of property are allowed last, but only to the extent that the gross income from the activity is more than the deductions under the first two categories. The deductions for depreciation and amortization belong in this category.
  • Additional limit – Individuals must 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 alternative minimum tax purposes.

Hobby loss rules can be complicated. If you need assistance determining whether your activity qualifies as trade or business, or whether it is subject to the hobby loss rules, please give this office a call.