Reporting hobby losses is an audit red flag. IRS is on the hunt for taxpayers who year after year report large losses from hobby-sounding activities on Schedule C of the 1040 to help offset other income, such as wages, or business or investment earnings.
Revenue you collect from a hobby is taxable …
But you cannot deduct the related expenses. The 2017 tax law temporarily nixed through 2025 miscellaneous itemized deductions previously subject to the 2%-of-AGI threshold, including hobby expenses.
To deduct a Schedule C loss, you must show the activity is a business. It needs to be conducted with continuity and regularity in a businesslike manner, and you must have a reasonable, good-faith objective of making a profit from it.
IRS regulations provide a safe harbor. If your activity generates profit in three out of five consecutive years (or two out of seven years for horse breeding), the law presumes you’re in business to make a profit unless IRS establishes otherwise.
The hobby-business analysis is trickier if you can’t meet the safe harbor. That’s because the determination of whether an activity is properly categorized as a hobby or a business is then based on each taxpayer’s facts and circumstances.
IRS and the courts take nine factors into account: Expertise of the taxpayer and advisers. Manner in which the taxpayer carries on the activity. Time and effort put into the venture. Expectation that assets used in the activity may appreciate. Success in carrying on other activities. History of income and losses (the more years of large consecutive losses, the harder it is to demonstrate a profit motive unless the activity is still in its start-up stage). Amount of occasional profits. Elements of personal pleasure or recreation that one gets from the activity. And whether the taxpayer has substantial income from other sources.
No one factor is determinative, but some are routinely given more weight.
For example, managing and operating your activity in a businesslike manner can be very helpful in demonstrating an honest intent to make a profit from a venture, even though the activity has so far been generating only losses. Some tax professionals point to this as the most important factor. And this factor is under your control. You should open a separate bank account for the activity, maintain good records, keep receipts of all your expenses, advertise, have a business plan and revise as needed, and change operating methods or adopt new techniques to turn your venture around.
Other helpful factors to establish profit motive that are within your control: Ensure you have the knowledge, training or expertise to conduct the activity, or rely on the advice of industry experts. Also, devote lots of time and effort to the endeavor.
The hobby loss rules are often litigated in Tax Court. IRS usually wins, partly because it tends to settle cases in which it doesn’t believe it can prevail. But taxpayers have also pulled out a victory in a number of cases before the Court.
Did you get subsidies for buying insurance through an exchange last year?
Note this break on the premium tax credit that applies only to 2020 returns. If your advance premium payments exceeded the amount of the actual premium credit you’re entitled to for 2020, you needn’t repay any excess when filing your Form 1040. The most recently enacted stimulus legislation suspends this requirement for 2020. Nor are you required to attach Form 8962 to your return if you are in this situation. The process for individuals claiming a net premium tax credit for 2020 is unchanged. They must attach Form 8962 when filing their 2020 federal income tax returns.
What if you’ve already filed your return and repaid the excess subsidy?
There’s no need to amend it. The Service will make automatic adjustments to the return to reduce the repayment to zero and reimburse the filer as needed.
IRAs & Plans
A man’s IRA can be garnished to pay restitution to victims of his crimes. A chiropractor pled guilty to health care fraud after his business fraudulently billed insurance companies for services he performed without a license. As part of his sentence, he was ordered to pay restitution. To enforce the order, the government sought to garnish his IRA. He objected, claiming the IRA funds were exempt because they were needed to pay child support. An appeals court disagreed, saying the child-support exemption applies only to salary, wages and the like, but not to investment or retirement accounts (Clark, 5th Cir.).
Correction to our April 2 Letter on RMDs for individuals turning 72 in 2021: People who turn 72 this year can postpone taking their first RMD until April 1, 2022. In our April 2 Letter, we said April 18 instead of April 1. We apologize for the error.
Individuals have more time to file an amended tax return for 2017. You generally have three years from the due date of your original return to amend it by filing Form 1040-X to claim a refund. This means that the 1040-X to amend a 2017 individual tax return would normally be due on April 15, 2021. However, IRS says individuals have until May 17, 2021, to file the 1040-X for 2017. And if you never filed a 2017 federal return, but are otherwise eligible for a refund, you have until May 17 to submit an original 1040 to get the refund owed to you.
To amend your 2017 return, you’ll have to file a paper Form 1040-X. Only e-filed Forms 1040 or 1040-SR for 2019 or 2020 can be amended electronically.
Let’s take a look at the ABLE tax-preferred savings accounts for the disabled. These accounts generally allow people to make nondeductible contributions of up to $15,000 a year to help the disabled maintain their health, independence and quality of life. Lifetime payins are capped at the same level as the state’s 529 plan.
ABLE accounts can be opened only for people who became blind or disabled before age 26. Working individuals are eligible to open their own ABLE accounts and can make contributions to their accounts over the $15,000 annual payin cap. This additional yearly contribution is limited to the poverty level for a single person … $12,880 for 2021. This figure is higher for individuals living in Alaska or Hawaii.
Withdrawals of earnings are tax-free if used for housing, transportation, education, job training, health needs, etc. Earnings used for nonqualified purposes are taxed and hit with a 10% penalty. Account owners remain eligible for Medicaid, and balances of $100,000 or less don’t affect Supplemental Security Income benefits. Limited rollovers are allowed from a beneficiary’s 529 plan to an ABLE account.
Over 40 states have ABLE tax-preferred savings programs for the disabled. Ditto for D.C. Residents in the few outlying states without current active programs can open up ABLEs in another state that makes its program available to nonresidents.
Businesses can deduct 100% of restaurant meals in 2021 and 2022. The late 2020 stimulus law provides temporary relief from the 50% haircut that normally applies to the business meals write-off. The easing applies only to food and beverages purchased at a restaurant for takeout or dining in at the establishment. Client meals and meals on travel are included. The taxpayer or an employee must be at the meal, and the cost can’t be lavish or extravagant. Prepackaged food or beverages bought at a store or similar facility do not qualify for the 100% write-off. Neither does the cost of meals at an employer-operated facility such as a cafeteria.
Deducting race car expenses through a construction firm draws IRS scrutiny. A father and son owned an S corporation that built houses and developed real estate. The son enjoyed car racing, so the company purchased a race car body and parts for the son to restore and race. It deducted $121,000 on its return for these expenses. IRS nixed the write-off, and the Tax Court agreed. The firm claimed the expenses were for advertising. But the racing activity wasn’t conducted under the firm’s name, no company logo was visible on the car, and the firm could not prove to the Court that the activity led to new business connections. Also, the firm buried the deduction among its construction expenses on its Form 1120-S (Berry, TC Memo. 2021-42).
No R&D credits for a clothing design business, the Tax Court decides. The firm designs, manufactures and sells women’s clothing, mainly to retail stores. It follows a multistep process for conceptualizing, designing and developing clothes. The company claimed R&D credits on its tax return, which IRS later disallowed. According to the firm, its process of designing garments, fit testing and fabric testing constituted research and experimentation. IRS argued the process was nontechnical and dealt more with style and taste, and not research. The Court sided with IRS, saying that the design efforts are not qualified research (Max, TC Memo. 2021-37).
A narrowing of the R&D tax break is slated to begin in 2022. Currently, companies can choose to fully expense their research and development costs in the year they incur them. Donald Trump’s 2017 tax reform law changes this rule for amounts paid or incurred in taxable years beginning after Dec. 31, 2021. Starting in 2022, companies will have to amortize their R&D costs over five years. For research conducted outside the U.S., the amortization period is 15 years. Business groups are urging Congress and the White House to delay this change.
Small start-up businesses can offset the R&D credit against payroll taxes. They can opt to claim up to $250,000 of qualified research expenses to offset payroll taxes instead of income taxes. The election, which is available to firms in business for not more than five years that have gross receipts of less than $5 million, is made on Form 6765 and attached to the income tax return. Firms use Form 8974 to figure the credit and claim it on Form 941 for the period after the tax return is filed. Note that the payroll tax credit cannot exceed the employer’s share of Social Security tax for the quarter. Any excess credits can be carried forward to the next quarter.
Businesses get more IRS guidance on a COVID-related payroll tax break:
The employee retention tax credit. The guidance covers the ERTC changes that are applicable for the first two quarters of 2021. See IRS Notice 2021-23. ERTC changes enacted under the American Rescue Plan Act of 2021 aren’t included.
Casino payments to Native American tribal members are taxable. A tribe that built a casino on tribal land made payments to its members from a gross receipts tax on casino revenue. Each member got over $100,000 annually. The members didn’t report the payments as income, claiming that the amounts were exempt from federal income tax. Not so, says an appeals court (Clay, 11th Cir.).
Cases involving passport revocations are now coming before the Tax Court. A federal statute allows the Dept. of State to deny or revoke U.S. passports of individuals with federal tax debts of $54,000 or more on whom a tax lien or levy has been filed. IRS certifies to State the names of those with debt who qualify. In this case, a man who owed $475,000 in delinquent taxes over multiple years claimed that the Revenue Service erroneously certified his debt to State. The Court decided IRS acted properly and tossed the case (Rowen, 156 TC No. 8).
A new e-mail scam is targeting staff and students at colleges and universities. The fake e-mails display the IRS logo and ask recipients to click a link and submit a form to claim tax refunds. They also ask for identifying information. The subject line varies but generally references the words “tax refund payment.” Don’t click on any links in the e-mail. Instead, send it to IRS at firstname.lastname@example.org.
Do you disagree with an IRS audit determination? Think about appealing it.
IRS’s Office of Appeals is an independent office within the Revenue Service that is separate from the exam and collection divisions. As a general rule, taxpayers can request an appeal by submitting a written protest or statement setting forth the issues in dispute and the reasons for disagreement.
Cases in Appeals last on average seven to eight months, starting from the date Appeals receives the case until it’s resolved or closed. This time frame applies to cases received from the exam or collection division that haven’t been petitioned to Tax Court.
Appeals has the authority to lower the tax owed to settle the dispute. The office weighs the probable outcomes if the case were to end up in court and can offer a settlement based on that calculation. Not all disputes in Appeals end up meriting a compromise, according to the chief of appeals. But many do.
IRS auditors have their marching orders on examining retailers. An updated audit guide tells agents what issues to look for in various businesses, such as grocery stores, online retailers, mobile food trucks, auto dealers, gas stations, auto body shops, liquor stores and more. Two big items that receive special emphasis in the handbook are ways to sniff out underreported income and whether the business is properly figuring cost of goods sold and accounting for inventory, if required. Other issues include depreciation, cost segregation and deducting expenses. Go to www.kiplinger.com/letterlinks/retailerag to view the complete guide.
The Biden administration wants IRS to beef up its enforcement activities.
And it is proposing more money for the Revenue Service for this purpose. In total, the proposal would hike IRS’s enforcement budget by $900 million. The extra funding would allow IRS to conduct more audits of wealthy individuals and large corporations. In 2019, IRS audited 2.4% of individuals reporting $1 million or more of income on their returns. This is way down from 8.36% in 2010. As for large regular corporations … those with assets in excess of $10 million … IRS in 2019 audited between 3.2% and 49.9% of them, depending on the firm’s size, far lower than the 2010 exam coverage, which ranged from 13.4% to 98%.
Congress will likely OK higher IRS funding … but not as much as IRS wants.