Taxpayers are often confused by the differences in tax treatment between businesses that are entered into for profit and those that are not, commonly referred to as hobbies. Recent tax law changes have added to the confusion. The differences are:
Businesses Entered Into for Profit – For businesses entered into for profit, the profits are taxable, and losses are generally deductible against other income. The income and expenses are commonly reported on a Schedule C, and the profit or loss—after subtracting expenses from the business income—is carried over to the taxpayer’s 1040 tax return. (An exception to deducting the business loss may apply if the activity is considered a “passive” activity, but most Schedule C proprietors actively participate in their business, so the details of the passive loss rules aren’t included in this article.)
Hobbies – Hobbies, on the other hand, are not entered into for profit, and the government currently does not permit a taxpayer to deduct their hobby expenses but does require the income from the activity to be declared. (Prior to the changes included in the Tax Cuts and Jobs Act of 2017, hobbyists were allowed to deduct expenses up to the amount of their hobby income as a miscellaneous itemized deduction on Schedule A. Being able to take this deduction is suspended for years 2018 through 2025.) Thus, hobby income is reported on Schedule 1 of their 1040 and no expenses are deductible.
So, what distinguishes a business from a hobby? The IRS provides nine factors to consider when making the judgment. No single factor is decisive, but all must be considered together in determining whether an activity is for profit. The nine factors are:
(1) Is the activity carried out in a businesslike manner? Maintenance of complete and accurate records for the activity is a definite plus for a taxpayer, as is a business plan that formally lays out the taxpayer’s goals and describes how the taxpayer realistically expects to meet those expectations.
(2) How much time and effort does the taxpayer spend on the activity? The IRS looks favorably at substantial amounts of time spent on the activity, especially if the activity has no great recreational aspects. Full-time work in another activity is not always a detriment if a taxpayer can show that the activity is regular; time spent by a qualified person hired by the taxpayer can also count in the taxpayer’s favor.
(3) Does the taxpayer depend on the activity as a source of income? This test is easiest to meet when a taxpayer has little income or capital from other sources (i.e., the taxpayer could not afford to have this operation fail).
(4) Are losses from the activity the result of sources beyond the taxpayer’s control? Losses from unforeseen circumstances like drought, disease, and fire are legitimate reasons for not making a profit. The extent of the losses during the start-up phase of a business also needs to be looked at in the context of the kind of activity involved.
(5) Has the taxpayer changed business methods in an attempt to improve profitability? The taxpayer’s efforts to turn the activity into a profit-making venture should be documented.
(6) What is the taxpayer’s expertise in the field? Extensive study of this field’s accepted business, economic, and scientific practices by the taxpayer before entering into the activity is a good sign that profit intent exists.
(7) What success has the taxpayer had in similar operations? Documentation on how the taxpayer turned a similar operation into a profit-making venture in the past is helpful.
(8) What is the possibility of profit? Even though losses might be shown for several years, the taxpayer should try to show that there is realistic hope of a good profit.
(9) Will there be a possibility of profit from asset appreciation? Although profit may not be derived from an activity’s current operations, asset appreciation could mean that the activity will realize a large profit when the assets are disposed of in the future. However, the appreciation argument may mean nothing without the taxpayer’s positive action to make the activity profitable in the present.
There is a presumption that a taxpayer has a profit motive if an activity shows a profit for any three or more years within a period of five consecutive years. However, the period is two out of seven consecutive years if the activity involves breeding, training, showing, or racing horses.
All of this may seem pretty complicated, so please call this office if you have any questions or need additional details for your particular circumstances.
Taxpayers often will hire an individual or firm to provide services at the taxpayer’s home. Because the IRS requires employers to withhold taxes for employees and issue them W-2s at the end of the year, the big question is whether or not that individual is a household employee.
Determining whether a household worker is considered an employee depends a great deal on circumstances and the amount of control the hiring person has over the job and the worker they hire. Ordinarily, when someone has the last word about telling a worker what needs to be done and how the job should be done, then that worker is an employee. Having a right to discharge the worker and supplying tools and the place to perform a job are primary factors that show control.
Not all those hired to work in a taxpayer’s home are considered household employees. For example, an individual may hire a self-employed gardener who handles the yard work for that individual as well as some of the individual’s neighbors. The gardener supplies all tools and brings in other helpers needed to do the job. Under these circumstances, the gardener isn’t an employee and the person hiring him/her isn’t responsible for paying employment taxes. The same would apply to the person hired to maintain an individual’s swimming pool or to contractors making repairs or improvements on the home.
Contrast the following example to the self-employed gardener described above: The Johnson family hired Maclovia to clean their home and care for their 3-year old daughter, Kim, while they are at work. Mrs. Johnson gave Maclovia instructions about the job to be done, explained how the various tasks should be done, and provided the tools and supplies; Mrs. Johnson, and not Maclovia, had control over the job. Under these circumstances, Maclovia is a household employee, and the Johnsons are responsible for withholding and paying certain employment taxes for her and issuing her a W-2 for the year.
W-2 forms are to be provided to the employee by January 31 of the year following the year when the wages were paid and the government’s copy of the form – sent to the Social Security Administration – is also due by January 31.
If an individual you hire is considered an employee, then you must withhold both Social Security and Medicare taxes (collectively often referred to as FICA tax) from the household employee’s cash wages if they equal or exceed the $2,100 threshold for 2019.
The employer must match from his/her own funds the FICA amounts withheld from the employee’s wages. Wages paid to a household employee who is under age 18 at any time during the year are exempt from Social Security and Medicare taxes unless household work is the employee’s principal occupation.
Although the value of food, lodging, clothing or other noncash items given to household employees is generally treated as wages, it is not subject to FICA taxes. However, cash given in place of these items is subject to such taxes.
A household employer doesn’t have to withhold income taxes on wages paid to a household employee, but if the employee asks to have withholding, the employer can agree to it. When income taxes are to be withheld, the employer should have the employee complete IRS Form W-4 and base the withholding amount upon the federal income tax and FICA withholding tables.
The wage amount subject to income tax withholding includes salary, vacation and holiday pay, bonuses, clothing and other noncash items, meals and lodging. However, if furnished for the employer’s convenience and on the employer’s premises, meals are not taxable, and therefore they are not subject to income tax withholding. The same goes for lodging if the employee lives on the employer’s premises. In lieu of withholding the employee’s share of FICA taxes from the employee’s wages, some employers prefer to pay the employee’s share themselves. In that case, the FICA taxes paid on behalf of the employee are treated as additional wages for income tax purposes.
A household employer who pays more than $1,000 in cash wages to household employees in any calendar quarter of either the current or the prior year is also liable for unemployment tax under the Federal Unemployment Tax Act (FUTA).”
Although this may seem quite complicated, the IRS provides a single form (Schedule H) that generally allows a household employer to report and pay employment taxes on household employees’ wages as part of the employer’s Form 1040 filing. This includes Social Security, Medicare, and income tax withholdings and FUTA taxes.
If the employer runs a sole proprietorship with employees, the household employees’ Social Security and Medicare taxes and income tax withholding may be included as part of the individual’s business employee payroll reporting but are not deductible as a business expense.
Although the federal requirements can generally be handled on an individual’s 1040 tax return, there may also be state reporting requirements for your state that entail separate filings.
Another form that is required to be completed when hiring a household employee who works for an employer on a regular basis, is the U.S. Citizenship and Immigration Services (USCIS) Form I-9, Employment Eligibility Verification. By the first day of work, the employee must complete the employee section of the form by providing certain required information and attesting to his or her current work eligibility status in the United States. The employer must complete the employer section by examining documents (acceptable documents are listed on the I-9) presented by the employee as evidence of his or her identity and employment eligibility. The employer should keep the completed Form I-9 in his or her records and make it available upon request of the U.S. government. It is unlawful to knowingly to hire or continue to employ an alien who can’t legally work in the United States.
If the individual providing household services is determined to be an independent contractor, there is currently no requirement that the person who hired the contractor file an information return such as Form 1099-MISC. This is so even if the services performed are eligible for a tax deduction or credit (such as for medical services or child care). The 1099-MISC is used only by businesses to report their payments of $600 or more to independent contractors. Most individuals who hire other individuals to provide services in or around their homes are not doing so as a business owner.
Please call this office if you need assistance with your household employee reporting requirements or need information related to the reporting requirements for your state.
As much as the Internet has changed our lives for the good, it has also opened us up to threats from crooks from all over the world. They are smart and always coming up with a new trick to separate you from your hard-earned dollars or with an illegal way to use your stolen ID. They apply for loans and credit cards with stolen IDs, file fraudulent tax returns, make purchases with stolen credit card info, and tap into your bank account with stolen account information, and the list goes on. As a result, everyone needs to be very careful and mindful of the tricks used by these scammers to not end up becoming a victim.
This office is committed to using safeguards that protect your information from data theft. To further protect your identity, you can also take steps to stop thieves. This article looks at a variety of tricks and schemes crooks use to dupe individuals, along with actions you can take to avoid being scammed, keep your computer secure, avoid phishing and malware, and protect your personal information.
ID Theft – The primary information ID thieves are looking for is your name, Social Security number, and birth date. So, constantly be aware of where you use that information, and always question anyone’s need for it when they ask. The fewer institutions that have your ID information, the lower the chances your data will be hacked. Treat personal information like cash – don’t hand it out to just anyone. Social Security numbers, credit card numbers, and bank and even utility account numbers can be used to help steal a person’s money or open new accounts. Every time you receive a request for personal information, you should think about whether the request is truly necessary. Scammers will do everything they can to appear trustworthy and legitimate.
Stolen IDs are also frequently used by cyber thieves to file fraudulent tax returns in your name, to take advantage of refundable tax credits such as the earned income tax credit, the child tax credit and the American Opportunity Education Credit, leaving you to deal with the IRS’s identity theft protocol.
What’s in Your Wallet or Purse – What is in your wallet or purse can make a big difference if it is stolen. Besides the credit cards and whatever cash or valuables you might be carrying, you also need to be concerned about your identity being stolen, which is a far more serious problem. Think about it: your driver’s license has 2 of the 3 keys to your identity. And if you also carry your Social Security card, bingo! An identity thief then has all the information needed.
Phony E-mail – Be aware that an unsolicited e-mail with a request to download an attachment or click on a URL could appear to be from someone you know, such as a friend, work colleague or tax professional. It could be that their e-mail has been hacked and someone else is sending the e-mail, hoping to trick you into some scam. Be alert for suspicious wording or content, and don’t click on any embedded links or attachments if there is any doubt.
Pop-up Ads – Don’t assume Internet advertisements, pop-up ads, or e-mails are from reputable companies. If an ad or offer looks too good to be true, it most likely is not true. Take a moment to check out the company behind it. Type the company or product’s name into a search engine with terms like “review,” “complaint” or “scam.”
Only Access Secure Websites – Only provide personal information over reputable, encrypted websites. Shopping or banking online should be done only on sites that use encryption. People should look for “https” at the beginning of a Web address (the “s” stands for “secure”) and be sure “https” is on every page of the site.
Avoid Phishing Scams – The easiest way for criminals to steal sensitive data is simply to ask for it. Learn to recognize phishing e-mails, calls or texts from crooks that pose as familiar organizations such as banks, credit card companies or even the IRS. These ruses generally urge taxpayers to give up sensitive data such as passwords, Social Security numbers and bank account or credit card numbers. They are called phishing scams because they attempt to lure the receiver into taking the bait.
For example, you might get an e-mail disguised as being from your credit card company asking you to verify your password. Companies will never do that because only you have that information, which is why you have to change it if you forget it.
Security Software – It is good practice to use security software. An anti-malware program should provide protection from viruses, Trojans, spyware and adware.
Set security software to update automatically so it can be upgraded as threats emerge. Also, make sure the security software is on at all times. Invest in encryption software to ensure data at rest is protected from unauthorized access by hackers or identity thieves.
You should never download “security” software from a pop-up ad. A pervasive ploy is a pop-up ad that indicates it has detected a virus on your computer. Don’t fall for it. The download most likely will install some type of malware. Reputable security software companies do not advertise in this manner.
Educate Children – Today’s children are probably more adept at using the Internet than their parents but are not mindful of the hazards. Educate your children about not giving out or posting online their Social Security numbers or birth dates. It may also be appropriate not to allow them to use a device that contains sensitive information such as tax returns, financial links, etc. It is not uncommon for crooks to use children’s IDs to file fraudulent tax returns. Also, block your children from freely downloading apps to their mobile devices without parental supervision.
Taxpayers have reported an increase in e-file problems because their children’s SSNs have already been used in a previously e-filed return, which results in the e-filed return being rejected.
Passwords – Use strong passwords. The longer the password, the tougher it will be to crack. Most sites require a minimum of eight characters, with at least one number and one character. Many sources suggest using at least 10 characters; 12 is ideal for most home users. Mix letters, numbers and special characters. Try to be unpredictable – don’t use names, birthdates or common words. Don’t use the same password for many accounts, and don’t share them on the phone, in texts or by e-mail. Consider using a passphrase versus a password. And remember, legitimate companies will not send messages asking for passwords.
Phony Charities – The fraudsters pop up whenever there are natural disasters, such as earthquakes or floods, trying to coax you into making donations that will go into the scammer’s pockets and not to helping the victims of the disaster. They use the phone, mail, e-mail, websites and social networking sites to perpetrate their crimes. The following are some tips to avoid fraudulent fundraisers:
Donate to known and trusted charities. Be on the alert for charities that seem to have sprung up overnight in connection with current events.
Ask if a caller is a paid fundraiser, who he/she works for and what percentages of the donation go to the charity and to the fundraiser. If any clear answers are not provided, consider donating to a different organization.
Don’t give out personal or financial information—including a credit card or bank account number—unless the charity is known and reputable. You might end up donating more than you had planned on.
Never send cash. The organization may never receive the donation, and there won’t be a record for tax purposes.
Never wire money to a charity. It’s like sending cash.
If a donation request comes from a group claiming to help a local community agency (such as local police or firefighters), ask the people at the local agency if they have heard of the group and are getting financial support.
Verify the charity – Check out the charity with the Better Business Bureau (BBB), Wise Giving Alliance, Charity Navigator, CharityWatch or IRS.gov.
Impersonating the IRS – Thieves will try to impersonate the IRS in an attempt to frighten you into making a quick payment, without checking on the validity of you owing any taxes.
The very first thing you should be aware of is that the IRS never initiates contact in any other way than by U.S. mail. So, if you receive an e-mail or a phone call out of the blue with no prior contact, then it is a scam. DO NOT RESPOND to the e-mail or open any links included in the e-mail. If it is a phone call, simply HANG UP.
Additionally, it is important for taxpayers to know that the IRS:
Never asks for credit card, debit card or prepaid card information over the telephone.
Never insists that taxpayers use a specific payment method to pay tax obligations.
Never requests immediate payment over the telephone.
Will not take enforcement action immediately following a phone conversation. Taxpayers usually receive prior written notification of IRS enforcement action involving IRS tax liens or levies. Some scammers even threaten immediate arrest if the payment is not made immediately – don’t be bullied by these criminals.
When in question, never make tax payments or provide any information without calling this office first.
Back Up Files – No system is completely secure. Back up important files, including federal and state tax returns, business books and records, financials and other sensitive data onto remote storage, a removable disc or a back-up drive.
If It Is Too Good to Be True, It Probably Isn’t – Many e-mail scams are based around supposed foreign lotto winnings, foreign inheritances and foreign quick-buck investment schemes. Don’t let the lure of the dollar signs cloud your better judgement. The only one that makes out in these instances is the cyber crook.
Please call this office if you have any questions.
Starting a small business can be one of the most exciting and rewarding events in someone’s life. But it can also be extremely stressful. If you’re thinking about becoming an entrepreneur, you might have more questions swirling around in your mind right now than you can count. Don’t despair. This is completely normal. After all, it shows you’re serious about your business venture and care enough to want to do things the right way. Before moving forward with a new business idea, ensuring you know the answers to the following vital questions is crucial.
1. Does your startup idea meet a need? Before starting a small business, you need to know if your product or service will meet a need those in your target market have. It doesn’t matter how special your potential product or service offerings are to you. If you can’t convince others to care about them, your small business won’t be a success.
2. Is your plan feasible? Learning things on the fly isn’t smart in the business world. Rather than taking a blind leap of faith, determine if your plan is actually feasible before moving forward. For instance, will you be able to afford to put your plan into action? Will your loved ones commit to the ways this venture might affect them? Starting a small business isn’t for the faint of heart. Do you have the ambition and determination to see your vision through?
3. How much financing do you need? Not adequately estimating financing needs is a common mistake of entrepreneurs. To avoid this pitfall, strive to perform an accurate cost analysis. Approximate both foreseen and unexpected expenses for the first year. Also, determine how long it will take you to become profitable. When creating a cost analysis, be realistic. Don’t count on things going perfectly. Despite your best efforts, they most certainly won’t.
4. Where will your company be located? The type of small business you want to start will largely determine where it should be located. For example, you wouldn’t attempt to open a ski lodge in sunny, balmy Florida. Generally, you’ll want to find a location with lots of foot traffic. If you’re a new entrepreneur looking to break into an already crowded market, locating your business near your competitors might be a good idea. According to Biz Brain, you’ll already have a built-in market in the location. But if you’re competing in a saturated market with major brand-name competition, locating your business a short distance away from your competitors may be your best bet.
5. Who will comprise your customer base? If you’re thinking about starting a small business, you likely already have a vague idea about who will comprise your customer base. However, delving into the profiles of potential clients of your company is a smart idea. During this research, you can study characteristics such as age, gender, buying triggers and general preferences. This should help you fine-tune your marketing efforts and target your products or services to the people who would most benefit from them.
6. When can you expect to be profitable? The old adage is that you should expect to wait at least a year until your startup becomes profitable. But times are changing. Innovations in technology and communication mean entrepreneurs can start companies with little to no overhead nowadays. This rings especially true for service-oriented companies. Therefore, having an astute business plan is essential. A good business plan will help you predict when you may start turning a profit.
7. What setbacks can you anticipate? The road to small business success can be a bumpy one, so anticipating setbacks is important. One of the most common ones is failing to meet revenue expectations. This can sometimes be blamed on overestimating the amount of business your company will generate in the early days of its existence. A second setback startups can face is losing vital employees. If you plan to start a sole proprietorship, this isn’t an issue. But if you’re launching a business venture with one or more partners, someone might decide to jump ship. To prevent your company from disintegrating into shambles, develop an exit plan that can be utilized if a partner wants to get out.
8. Do you need solid advisors? Starting a small business can be overwhelming. This is especially the case if you try to do everything yourself. Surprisingly, the CountingWorks What Small Business Owners Value Most in 2019 survey reveals that 60% of small business owners handle their budgeting themselves. Unfortunately, the U.S. Small Business Administration Office of Advocacy’s 2018 Frequently Asked Questions says only about half of small businesses survive past five years. To boost your chances of long-term success, surround yourself with solid advisors. For instance, experienced financial advisors can help you with accurate budgeting. Legal advisors can assist you with contracts and permits.
9. How will you lure the best talent to your company? Obviously, offering prospective employees a competitive salary can help you lure the best talent to your company. But when you’re just starting a business, this might not be an option. To compensate for this, providing employees with growth bonuses is a good alternative. Offering employees flexible scheduling options and wellness perks such as an onsite gym, a break room stocked with healthy snacks, and standing desks may also attract promising talent to your company.
10. Should you start more than one company at once? Do you have multiple ideas for new small businesses? Perhaps you’re eager to get more than one startup running at the same time. While this might be tempting, starting out with one company is best. You can put all your energy into getting it profitable and stable. This will prevent you from spreading yourself and your resources too thin. You can always branch out later if your first business takes off.
Starting a business can be quite an undertaking. Therefore, planning correctly and thoroughly is critical. Before you can enjoy small business success, you’ll need to learn the answers to the above questions.
There is an excellent chance that even if you’re an expert in your particular industry, you’re probably not an expert in small business finances. This may not seem like that big of an issue on the surface. However, in order to make the best decisions possible for your company, you need to have complete and accurate information to work from. It’s easy to see how failing to grasp the financial side of the equation can quickly cause problems everywhere else.
For example, just because your company looks profitable on the surface doesn’t necessarily mean that this is the case. In fact, there are a number of clear ways in which your SMB might not be as profitable as it could be that are certainly worth exploring.
Not Everything Is About Sales
Maybe the most important thing for you to understand is that just because sales are high does NOT mean that your company is experiencing profitable growth in the way you think it is. This is actually just one small part of a much larger (and more complicated) story.
Sales could be going up AND profits could be going down in a number of ways. Maybe you’re selling a higher volume of low-margin items while also not selling as many high-margin goods. Perhaps the cost to actually make your product has increased higher (and faster) than your revenue. It’s possible that your operating expenses are so high that even though you’re increasing sales, your business is still not as profitable as it could be.
The lesson here is that you need to look beyond sales growth to find out what is really happening with your company. If you do discover a problem like those outlined above, come up with a specific solution designed to address those particular issues in the most effective way possible.
Dive Deep Into Your Line-Item Profits
Likewise, you need to recognize the difference between bottom-line profits and line-item profits — particularly in terms of the health of your business year-over-year. Instead of just looking at the bottom line, look at the tangible contribution that each product or service makes to that bottom line.
Break down all of your sales by product lines, individual products and services. Is Product A losing so much money that it is eating into the profits generated by the hugely successful Product B? If that’s the case, Product B probably isn’t as “successful” as you thought it was.
Don’t Forget About Margins
Finally, paying attention to your profit margin percentages can tell you a number of critical things about the financial health of your company, essentially all at the same time. You’ll be able to determine whether:
You’re correctly pricing and promoting your products in a way that drives profitable growth.
All of the products and services you’re offering are profitable to begin with.
The true value of the relationships you’re forging with your customers, and how long they last on average.
If you’re allocating resources in the most efficient way possible, thus maximizing profitability whenever possible.
Again — figuring out whether or not your small business is as profitable as it can be involves a lot more than just looking at any one particular line item on a balance sheet. Often, it is a combination of many things — each representing their own individual piece of the puzzle that is your company. Only by understanding the bigger picture will you have the information you need to see where you truly stand… and what you need to do about it moving forward.
In the end, the most important thing for you to understand is that while you may be an expert in running your small business, you’re probably not (nor are you expected to be) an expert in small business finances. Those are two entirely separate concepts and should always be treated as such.
Partnering with the right financial professional isn’t something that you do after your organization is already up and running. It should be a natural part of the process of launching a business in the first place. There are so many decisions that will ultimately affect your cashflow and taxes moving forward — from the financial structure that you set up to the entity you choose during formation. One wrong move at any of these points can artificially limit your ability to make money, and that is a difficult position for any entrepreneur to be in.
Instead, partner with a seasoned financial professional immediately and look to this person for insight and guidance as often as possible. If nothing else, they will make sure that the foundation upon which your company is built is as strong as possible — thus eliminating many and even all of the potential issues that could hold you back in the future.