Filing a Tax Return For Your LLC

Rosebud business solutions is a boost for businesses

Photo by Lancashire County Council on Flickr.com

If you’ve started a new business and you filed the Articles of Organization in your state to become an LLC, then here are some things you need to know about filing taxes for your new company.

First, there is no such thing as an LLC tax return.  I know that sounds crazy, but it’s true.  Every year, thousands of people walk into their accountants’ offices and say, “I want to file an LLC tax return!”   This is what accountants joke about at their conventions and at the water cooler.  We even post silly You Tube videos about it.  This post is to help you not be the butt of some dumb accounting joke.

An LLC is a Limited Liability Company.  One of the most common mistakes people make is that they think LLC means “Corporation”, it doesn’t.  If you have an LLC, you probably are not going to file a corporation return (although you might, I’ll discuss that later).

The IRS considers an LLC to be something they call a “disregarded entity.”  That means that it doesn’t have a specific tax document that goes with it.  If your LLC only has one “member” (member is LLC-speak for owner) then the default tax return for your LLC is a Schedule C which is part of your 1040 income tax return.  It’s due on April 15th just like any other individual tax return.

If your LLC has two or more members, then by default you are considered to be a partnership and you must file a partnership return, form 1065.  Form 1065 is due on April 15th also, but it’s a good idea to get it done sooner because the information on the 1065 needs to go onto your personal tax return before you file it.   When your accountant prepares the 1065, she’ll also prepare a K-1 form that will be used to prepare your personal income tax return.

So, if you have an LLC, the default tax return you might file would be a Schedule C as part of your individual income tax return, or a 1065 partnership return (and you’d receive a K1 form so you could put your partnership income on your personal tax return).

Instead of using the default filing options, you can choose to have your LLC treated as an S corporation or a C corporation for income tax purposes.  It’s very rare to choose to have your LLC treated as a C corporation.  Usually, if a person wanted to pay corporation tax rates, she would file articles of incorporation to begin with.  But one advantage to filing as an LLC and then electing to be taxed as a C corporation would be to avoid some of the stringent reporting and meeting requirements that C corporations have.  Usually, it’s not advantageous tax-wise to be treated as a C-Corporation, but there are always some exceptions.  If you do go this route, you will need to file an election to be taxed as a corporation: form 8832.  The tax return for a C-Corporation is called an 1120.  You must file the 1120 or the extension by March 15th or you will be assessed a late filing penalty even if you owe no tax.  A C-Corporation pays taxes on its income and pays wages and/or dividends to the owner.

The more common corporate tax treatment for LLCs is to be taxed as an S Corporation.   A Sub-chapter S corporation passes its profits through to the owner.  If you elect to be a Sub S Corporation, you must pay yourself a wage.  For most businesses, the purpose behind a Sub-chapter S corporation is to avoid paying self-employment taxes.  There are two things you must know:

1. A Sub S Corporation isn’t always the best way to avoid paying self-employment taxes and,

2. You’re not allowed to say that you’re trying to avoid paying self-employment taxes, even though that’s pretty much the reason anybody ever makes the Sub S election.

To make the election to be taxed as a Sub S Corporation, you will need to file form 2553.  A Sub S Corporation tax return is called an 1120S form and it is due by March 15th.  The S corp does not pay income tax; the income from the S corp will be reported on a K1 and will flow through to your personal tax return.

If you make an election to be taxed as a C or an S Corp, you will have to keep that designation for at least five years unless you get special permission from the IRS to change.  You want to make sure you really want to make the election for corporate tax treatment before filing those forms.

Here’s my really important tax advice:  Assume that you’re filing your LLC return either as a Schedule C (sole proprietor) if you’re a solo owner, or a 1065 partnership return if you have more than one owner, at least for the first year.  But then, sit down with your preparer and run the numbers all three ways, (Schedule C, S-Corp, C-Corp) to see what makes the most sense for your business.  Make some projections about your future income and expenses and take into account the deductions that you may have missed last year but won’t miss again.  Smart planning can save you thousands of dollars in taxes over the years to come.  Saving on taxes helps your business grow and puts money in your pocket.

How to Boost Your Home Office Deduction

July 5, 2011 by · Leave a Comment
Filed under: Small Business, Tax Deductions 

Photo by Biking Nikon of Flickr.com

If you’ve claimed a home office deduction on your tax return, you’re familiar with the form—they ask you for the square footage of your home office and then they ask for the square footage of your home. Let’s say that your home is 2,000 square feet and your home office is 100 square feet, then your home office percentage is 5%. If your home operating expenses were $10,000 then you’d get to claim $500 for your home office deduction before claiming depreciation (because $500 is 5% of$10,000).
But did you know that if the rooms in your home are roughly the same size that you can figure the percentage based upon the number of rooms in your house? Say you had 8 rooms in your house, a kitchen, living room, dining room, family room, three bedrooms and your office. That would change your percentage to 12.5%, and now your deduction would be $1250—that’s more than double the difference.
Now if your home is like mine, your rooms aren’t all the same size and you can’t use the ‘number of rooms’ formula. But—the ‘number of rooms’ formula does help those of us who must use the regular square footage formula. You see, when you use the ‘number of rooms’ formula, you’re leaving out things like hallways, staircases, and bathrooms. When you’re determining the square footage for your whole home, you are allowed to deduct the following items from your total square footage:
o Hallways
o Staircases
o Bathrooms
o Crawlspaces
o Space occupied by heating and air conditioning units, and water heaters
o Foyers
o Outside walls
By reducing your overall square footage, you increase the percentage that you can use for your home office expense. Using the office mentioned above, let’s say the taxpayer measures out his stairs, foyer, hallways, etc. and finds that it reduces his overall square footage by 500 feet. Now his percentage would be 6.67% raising his deduction to by $167 to $667.
This might not seem like a huge savings, and certainly it will vary depending upon the size of your home and your expenses. The important thing here is that its extra tax savings to you without spending any additional cash. You’ve done nothing extra except re-measure your house.
Let’s add depreciation into the mix. Let’s say, for this same house, the owner’s purchased it for $250,000. $50,000 of that was attributed to the cost of the land so we’re depreciating $200,000. If 5% of the home were depreciated, the deduction would be $256 (200,000 x 5% x 2.54% depreciation rate). By increasing the percentage used to 6.67%, then the depreciation would be $342, an increase of $86.
So now, by doing nothing more than re-measuring your house, you’ve increased your home office deduction by $253 and, if you’re self employed and in the 25% tax bracket, you’ve just saved yourself $101 in taxes.
This is one of those cases where everyone’s results will be different, but the example that I used was pretty conservative. It’s highly likely that you can save even more than this example does, especially if your expenses are higher or your home office is larger to begin with.
You always want to take advantage of any tax issue that puts money in your pocket without you putting money out. Re-measuring your home for the home office deduction is like a little gift from the IRS to help you save money on your taxes.

Tax Tips for Artists: Why You Might Not Want to Donate Your Art

June 22, 2011 by · 8 Comments
Filed under: Self Employed, Small Business, Tax Deductions 
Paintbrushes

Photo by John Morgan on Flickr.com

If you’re an artist, you may have been asked to donate a piece of your artwork for a good cause.  You might have also been told that it’s good PR for you, because people at the event will get a chance to see your work and bid on it.  And of course you’ve been told that your donation is tax deductible.

While it’s true that your donation is deductible, it’s not nearly as deductible for you as it is for me.  Come again?  You heard me right—your art donation is not as deductible for you as it is for me.  Let me give you an example:  Let’s say you donate a painting that would normally sell for $500.  If I bought that painting and donated it to a charity, I’d get to write off the full $500 on my tax return as a charitable deduction.  If you donate that painting instead, you can only write off the cost of the materials that you used to create that painting—depending upon what materials you’re using, that’s maybe $50 to $100.   

Additionally most artists are sole proprietors, their art income goes on a Schedule C on their regular 1040 tax return.  Your charitable donation can’t be counted as a business expense, it must go on your Schedule A with your other personal itemized deductions.  If you don’t already itemize your deductions on a Schedule A, that donated painting gives you no tax benefit whatsoever.

I’m not saying that you can never donate to charity, I like charities and I think they deserve donations.  It’s just that when you donate your art, you’re not getting much bang for your buck.  So what are your alternatives?

One thing is to pay to “advertise.”  For example:  I support a small, local ballet company.  I used to just donate money to them, but now instead I purchase an ad in their performance program.  They get the money they need and I get a business deduction for advertising.  This is especially good for me.  Before, being in the 25% tax bracket, my $100 donation was worth $25 off my taxes.  Now, as a business expense, my $100 advertisement reduces my taxes by $40 ($25 from my regular tax plus an additional 15% for my self-employment taxes.)  The advertising option gives you the best tax value on your donation because you can use it to offset your self-employment taxes.

Do be careful about the charity advertising though.  I once did an ad thinking I was supporting a local organization, when really the money was going to an advertising agency.  The organization got some money, but most of it went to the promotional company.  I won’t make that mistake again. 

Another option for you is to donate the profits from one of your art pieces.  For example, let’s take that $500 painting; assume you paid $100 for your materials,that’s a $400 donation to the charity.  Most likely, that’s a better donation than what the charity would gain if they auctioned one of your pieces off.  If you’re in the 25% tax bracket, you still get a $100 reduction in your taxes.  It won’t help with your self-employment tax, but you do get the good feeling of making a donation and your art work sells for its actual retail value instead of some discounted auction price (another disadvantage of donating your art for charity.) 

There are many worthwhile causes out there that need and deserve your help.  If providing a piece of your art work is how you want to help, by all means do it.  Just remember, it’s not your best tax strategy.

Rethinking Your Auto Deduction

claiming actual versus mileage expenses for your auto

Green Hornet car, photo by Jan Roberg

Generally, when I’m filing a tax return for a business owner, I tend to use the mileage rate.  For many of my clients, it’s the best deduction for them financially.  For some of them, I use mileage because they don’t keep good enough records for me to use their actual expenses. 

To be honest, I hadn’t really pushed the actual expense method much, but with gas prices creeping upwards of $4 a gallon and the IRS mileage rate at only 51 cents a mile, it’s time to rethink strategy.  Remember, you never want to leave money that’s yours on the table for the IRS.  If you want to claim your actual auto expenses for your business, there are some things you need to know.

 First, whether you claim your mileage or your actual automobile expenses, you still need to keep records of your business mileage.  A real common mistake people make is they think that they can hand over a bunch of receipts and claim their actual business auto expenses.  It doesn’t quite work that way.  You have to track your business versus your personal miles in order to determine a percentage.  Let’s say you saved all of your receipts for your auto expenses and they totaled $5,000.  It means absolutely nothing if you aren’t able to tell me how many miles you put on your car this year and how many of those miles were for business.    Without the mileage information to go with it, the $5,000 in receipts is pretty worthless.   

Now I’m quite certain that people “make up” their mileage all the time.   But I also know, if you are selected for an audit and you have claimed auto expenses; I guarantee that your mileage log will be requested.  I guarantee it

So why set yourself up for losing an audit?  Keep good records, and you’ll have nothing to worry about.  What’s even better is that you may even find that you have a bigger deduction to claim than you would have had just by guessing at your miles.  (True story, client got audited, had to recreate his mileage log.  He used to lowball his mileage estimate to avoid an audit.  He’d listen to what the other guys in the office claimed and lowered his a little to be “safe.”  It didn’t work.  Turns out he underreported by about 5,000 miles.  That’s a $2500 deduction.  In his tax bracket that was worth $625.  Wouldn’t you like to have an extra $625?  He’s my best record keeper now.)

So now you’ve got your mileage log and you’ve determined that exactly 25% of your miles are used for business.  If we go back to the $5,000 of auto expenses you had, that would give you a deduction of $1,250.   You’d check that against what your deduction would be for claiming straight mileage.  As long as you claimed mileage the first year you put the car into service, you can switch back and forth between actual expenses and the mileage rate.  If you started with actual expenses, you have to stay with actual expenses until you change vehicles.

So if you’re claiming actual auto expenses this year, what do you need to keep track of?  Besides your mileage, you’ll want receipts for your gas, car washes, auto repairs, oil changes, tags, personal property taxes,  and insurance.  I can hear you thinking, “I don’t have receipts for my gas.  It’s too late to start for this year.”  Not really.  One nice thing about auto expenses is you don’t actually have to have a receipt for anything under $75—you may have to start saving the gas receipts soon, but most of us can still fill up for under $75, just barely anyway.  I always get my gas at the local shell station.  I always pay with my debit card.  I can go to my bank statement and tell you exactly how much money I spent in gas this year.  Granted, I’m boring and predictable (I do taxes for a living, give me a break!)  But I bet you can reconstruct your gasoline expenses too.   And from here on out, you can keep better records.  Please note–when I say you don’t need a receipt, that doesn’t mean you don’t need proof, you do need proof, you just don’t need to have the little printed receipt from the gas pump if the expense is under $75.

When you claim your actual expenses, you’ll also be claiming depreciation.  There are special rules and regulations about the depreciation you can claim on luxury cars, but most software programs these days will tackle that for you.  Remember that you’ll need information on the date your purchased the vehicle, the price you paid, and when you placed the car in service (using it for your business.)   Because you kept track of your mileage, you’ll know your exact business use percentage to claim as well.

But what about your mileage?  What if you haven’t been keeping records of that?  Once again it’s not too late.  In a perfect world, you have perfect records for the entire year.  But, if you have consistent auto usage, you can keep good records for 90 days and use those records to extrapolate the mileage for your return.  (Extrapolate is a pretty big word for the likes of me.  It basically means that if you’ve got good records for 90 days, we can make a pretty good guess as to how you did the rest of the year.)  A full year of tracking  is better, of course, but the 90 day rule has been accepted by the IRS in audits before so it’s a workable documentation plan. 

It’s really not too late to start tracking your actual auto expenses for your business.  But don’t wait much longer or it will be.

Tornados and Taxes, Reporting Your Casualty Loss on Your Tax Return

April 25, 2011 by · Leave a Comment
Filed under: St Louis County, Tax Deductions 
Casualty loss claims for tornado damage

Photo by Mark Witzling

We’ve had our fair share of tornados in Missouri this year, and plenty of damage too. Serious damage, we recently made international headlines with our Good Friday storms. You might have heard that you can claim a casualty loss on your tax return. While that’s true, for many people it’s not as helpful as you would hope. Here are the facts so you know what to expect.

First, we’re talking about a casualty loss on your tax return. All this means, is that you get a reduction of taxes that you would normally owe. If you’re already in an income situation where you don’t pay income tax, you will receive no tax benefit. This is important to know because people with low incomes are more likely to not have insurance, therefore their loss is greater. They want to claim their casualty loss, but it does them no good.

Second, you can only claim a casualty loss on your actual loss. If your insurance reimbursed you for the damage, then you have no loss to report on your tax return other than your deductible.
Finally, when we’re talking about casualty losses, we mean tornados, earthquakes, floods and things like that. If a tornado blows your roof off, that’s a casualty loss. If you need to replace your roof because it’s 20 years old, that’s normal wear and tear and does not count.

So what about those people who do have taxable income and also have a genuine loss they can claim, what happens? It’s probably easiest to explain with an example: Let’s say Fred owns a house that’s worth $200,000. The recent storm caused $50,000 worth of damage and his insurance company picked up $45,000 of the expense due to his $5,000 deductible. Fred has a $5,000 casualty loss.

Fred completes form 4684, the Casualties and Thefts form: http://www.irs.gov/pub/irs-pdf/f4684.pdf

We know that his loss is $5000, which goes on line 10 of the form. Then you subtract $100 because under the IRS rules, every casualty loss subtracts $100—that leaves a loss of $4900. Next, you subtract 10% of Fred’s adjusted gross income. If Fred makes $40,000 a year, you subtract $4,000; that leaves $900 for him to claim as a loss on his schedule A. If Fred itemizes his deductions, it will go on line 20 of his Schedule A. He’ll wind up paying $225 less in taxes. If Fred doesn’t already itemize, he might not even get that.

Remember, the casualty loss is dependent upon your income level. If Fred made $50,000 a year or more, he’d get nothing at all because 10% of his income would be more than the total amount of loss he could claim.

Everybody’s case will be different because there are so many variables to look at. If you have suffered a loss due to the recent tornados (or any other natural disaster) even if you won’t be able to claim a tax deduction for it, you might find the IRS Disaster and Loss Kit helpful. It has information on how to replace missing documents, a workbook for determining what you lost and what the value was, and other valuable information. It’s called Publication 2194 and you can access it through this link: http://www.irs.gov/pub/irs-pdf/p2194.pdf

Claiming Your Dog on Your Tax Return: Part 1

March 9, 2011 by · 16 Comments
Filed under: Tax Deductions 

 

Photo by Heartlover 1717.

The first thing you need to know is that you can’t claim your dog as a dependent on your tax return.  Never!   Don’t even think about it.  There are no special rules for St. Bernard’s or Great Danes.  It doesn’t matter how much your dog depends on you or that he’s a regular member of the family.  A dog can never be claimed as a dependent on your U.S. income tax return.

There are only two places where you could claim a dog on your tax return; the first is as a medical expense and the second is as a business expense.   Most importantly, it has to be a legitimate expense.  Dog expenses claimed on a tax return are likely to get audited.   You’ll want plenty of documentation.

Let’s look at medical expenses today.  I’ll post about dogs as a business expense later this week.  According to the IRS medical expense publication:  You can include in medical expenses the costs of buying, training, and maintain a guide dog or other service animal to assist a visually-impaired or hearing impaired person, or a person with other physical disabilities.  

If you have a seeing eye dog or a hearing assist dog, then you’ve got an easily proved legitimate expense.  Note that the IRS definition discusses “physical” disabilities, mental disabilities are conspicuously absent from this category. 

If your service dog is meant to help with a mental disability, you may be able to claim the animal under “impairment-related work expenses.”   This might actually work out to be an even better deduction than as a medical expense, if you qualify.

In order to be considered as disabled to claim an impairment-related work expense, you must have a physical or mental disability that functionally limits your being employed, or a physical or mental impairment that substantially limits one or more of your major life activities such as performing manual tasks, walking, speaking, breathing, learning, or working. 

I cannot stress enough the importance of legitimacy here.   You can’t just go online and purchase a “service dog” vest for your pooch and take him to work with you.  The service your dog provides must be necessary for you to do your work in a satisfactory manner. 

Here’s a question to ask yourself—if you were to be audited for your dog expense, could you obtain written letters from your doctor and your employer that your dog is necessary for you to work?  This is important.  I assisted an audit once where the man had claimed his dog as a medical expense.  The auditor was willing to allow the expense if the man obtained a letter from his psychiatrist that yes, the dog was part of the man’s treatment.  Although the psychiatrist admitted that he had recommended that the man get a dog, he would not issue a letter stating the dog was part of the man’s treatment and the case was lost.  If you intend to claim a dog as a medical expense (other than a seeing eye or hearing assist dog), it is absolutely essential that you have the support of your doctor.

Babysitting as a Charitable Donation

March 7, 2011 by · 1 Comment
Filed under: Tax Deductions, Uncategorized 

If you’re a parent and you use a babysitter or daycare provider to care for your child while you are at work, that’s a deductible expense. In general, both parents must work, or one must be disabled or in college in order to qualify. But did you know that hiring a babysitter to care for your child while you are performing charity work counts as a charitable donation? I didn’t until recently. In fact, if you read the IRS regulations, it’s pretty clear that it’s not allowed.

But, according to Kiplinger.com—the IRS lost a case in Tax Court trying to uphold that rule. The difference is, in this instance, you claim the child care expenses as a charitable donation instead of as a child care expense.

Now, in order to make such a claim, I would recommend that you keep excellent records of the time spent volunteering, the type of work performed, and the charity you worked for. Of course, if you spend two hours a week volunteering, but your child is in daycare for 30 hours a week, you can only deduct for the two hours of time you volunteered.

Small Business Basics

November 8, 2010 by · 25 Comments
Filed under: Self Employed, Tax Deductions, Uncategorized 

I’ve done a lot of posts about unusual small business deductions, but I haven’t done anything about the basics.  If you’re new to the small business world, that’s what you really need to know.  These are some of the basic, core facts that you need to know to prepare your small business taxes.

First, if you’re just starting out, and you haven’t filed any papers like articles of incorporation, and you don’t have any partners, then you’re considered to be a sole proprietor.  Your business tax return goes on a form called a Schedule C, and that’s part of your regular 1040 form.  Don’t file your personal taxes and then try to file your business return later, they’re one and the same thing.

What if I’m an LLC?  An LLC is a limited liability company, it’s not a corporation.  Most LLC’s will file as sole proprietors unless they have filed documents to be treated as an S corporation.  Then they file tax form 1120S.  LLCs that have partners will file partnership returns, form 1065.  This post is about sole proprietors who file Schedule C with their 1040 return.

A popular question I hear is, “How much money do I have to make to file a return?”  According to the IRS, if you make over $400 of self employment income, you are required to file a federal tax return.  This is very different from the minimum filing requirements of regular returns.  Once you’ve made over $400, that income is subject to self employment tax and the IRS is very keen on collecting your self employment tax.

Another common question is, “How will the IRS know that I’ve made over $400?”   The easiest way for the IRS to find out your income, assuming that you haven’t reported it yourself, is from forms 1099MISC.  Many companies hire people as contract labor and don’t withhold payroll taxes.  If you make over $600 from them, they are required by law to give you a form 1099MISC, showing how much they paid you.  A copy of that form also goes to the IRS.  That’s the most common way small businesses can get in trouble for underreporting their income.

Another way the IRS can find out that you’re not reporting your income is through your bank records.  Let’s say for example that all of your business transactions are for cash and you never receive a 1099MISC.  Although you wouldn’t get caught as quickly, let’s say you had an annual income of $20,000 from your all cash business.  Your spending would be out of line with your income and could trigger an audit.  A quick look at your bank statements would prove you weren’t reporting your income.  If you’re serious about starting a real business, do it right and have a plan for handling your taxes.  It will save you a lot of trouble in the future.

Small business income, unlike wage income, has one big disadvantage–it get’s taxed twice.  First, it’s taxed at your normal tax rate (10, 15, 25 or 28%) and then again at the self employment tax rate (15.3%.)  Let’s say you’re already in the 25% tax bracket for another job you have, your self employment income would then be taxed at 40% (the 25% plus the 15%.) 

Small business income also has one big advantage–you can reduce your self employment income by any expenses you had acquiring that income.  You may even have more business expenses than you have income, in that case, you can use your business losses to reduce your regular income, that lowers your overall income tax bill.  Now you don’t want your business to be losing money every year (that’s not really good business practice.)  But when you’re starting up, being able to deduct your losses is very helpful.

So what kinds of expenses can you deduct?  The key phrase that the IRS uses is anything that is “regular and necessary” for the business.  A good guideline is right on the Schedule C form.  Here’s a link to it right here:  Schedule C.  Advertising, legal and professional fees, auto expenses, insurance, rent, repairs and maintenance, supplies, and office expenses.   Meals and entertainment are deducted at 50% of what you spend (since the idea is that you’d have to eat anyway.)

If this is your first time filing taxes for your small business.  I recommend getting a professional to help you.  Even if you have a knack for the paperwork, it really helps to have someone else go over the possibilities of what you can deduct and make sure that the big things like depreciation (if you have that) are handled correctly.  If you get started on the right track, it’s easier to stay that way.

Business or Hobby?

October 26, 2010 by · 37 Comments
Filed under: Self Employed, Tax Deductions, Uncategorized 

Me and Batman

Batman stopped by my office the other day.  He usually doesn’t visit me in his Bat costume, but he had just done a charity fundraiser as Batman and had promised  the ladies in my office to visit us in costume.  (I’d just like to point out that not all of my friends and clients are super heroes.  I do know plenty of normal people.)

I recently did a post about a fellow who made a business out of appearing as Superman.  On a good day, Superman can take in some decent money.  After Batman’s successful fundraiser, he kind of wondered aloud about following in Superman’s footsteps and making occasional appearances for pay also.  While I recently made the case for Superman being a legitimate business, Batman’s income I believe would be a hobby.

How do you tell if something is a business or a hobby?  Sometimes it’s kind of hard to tell.  Everybody recognizes that if you open up an Ace Hardware store selling tools and duct tape you’ve got yourself a real business.  But what if you make purses and wallets out of duct tape and sell them at craft fairs?  Where does that fit in?  What if you breed your champion Cocker Spaniel and sell the puppies?  Dog breeding is a real business, but how many litters makes you a breeder?  It’s not all black and white.   Here are some guidelines to help you.

First, I want to point out the most important key ingredient that the IRS uses to determine if you are a real business:  a 1099MISC showing an amount under “non-employee compensation.”  There are numerous guidelines as to what constitutes a business versus a hobby and this one is never mentioned.  Yet it’s the most important factor as far as the IRS is concerned!  If you receive a 1099MISC, the IRS counts that as self-employment and they will tax you not just income tax, but an additional 15% self employment tax.  As a professional preparer, if I see one of those, even if I truly believe that your business should be classified as a hobby, I’m preparing a Schedule C showing you as a business.   That’s how the IRS is treating that income.

What’s the difference in how your income is classified and why is it important?  Business income is taxed at your regular income tax rate plus the self employment tax rate.  Let’s say your regular tax rate is 25%, then your business income is taxed at 40% (25% + 15% = 40%.)   The advantage of being treated as a business is that you can write off your direct business expenses against the income and you can even have a loss that will offset your other income.  Hobby income is taxed at your regular tax rate, there is no self employment tax so you pay less tax on hobby income.  The disadvantage is that although you can write off expenses against your hobby income, you can never take a loss.  Also, for many people, the hobby expense write off is a worthless deduction.  (It goes on the Schedule A under miscellaneous deductions subject to the 2% limitation rules.)

You cannot switch your business back and forth from hobby to business depending upon whether or not you have a profit or loss.  It’s okay to grow your hobby into a business.  It’s even okay to downgrade your business into a hobby.   But flip flopping for the sake of lowering your taxes is just going to land you in trouble with the IRS.  You need to put a little thought into it before you start claiming business losses.

If you’re not receiving 1099 MISC forms, what other tests can you use to prove your business is real and not a hobby?  One is the three year test–if you’ve shown a profit in three out of the past five years, then you’re considered a business.  This is a good rule, but it’s not completely hard and fast.  There are court cases proving businesses to be valid even though they’ve shown losses for more than three years.  Even though its a good rule of thumb, I don’t like to see people get too hung up on it, there are other tests.

Is the business carried out with the intention to make a profit?  Does the taxpayer (or the taxpayer’s advisors)  have the knowledge to make the business a success?   Does the taxpayer spend enough time on the business to indicate a profit motive?  Has the taxpayer made a profit on similar activities in the past?   The answers to these questions is why I put Superman in the business category and not the hobby category.  Superman had previous paid experience as a costumed character and model, and he also had a website devoted to his business and posted blogs about how to be a superhero.  He clearly devotes a great deal of time to his business.   Batman,on the other hand, wouldn’t really pass these tests, that’s why I consider his income to be hobby income.

One final point.  Batman takes offense at Batman labeled as a hobby.  “Batman isn’t a hobby, it’s a calling.”  Like I said in the beginning, some of my friends are normal.

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Business Expenses for Unusual Occupations

October 13, 2010 by · 1 Comment
Filed under: Jobs, People, Self Employed, Tax Deductions, Uncategorized 

Charlee Chartrand as Superman from the Post Dispatch article, see link for full story.

 What do you do for a living?  Are you in advertising, construction, real estate?  When you tell people what your job is do they seem to have a grasp of what that means?  Some people’s jobs aren’t so easily defined, like Superman for example. 

Actually, his name is Charlee Chartrand and he dresses as Superman for his job.  This is not your every day occupation.  Now I don’t know Mr. Chartrand and I don’t do his taxes, if I did, my confidentiality rules wouldn’t allow me to talk about him.  I read about him in Sunday’s Post Dispatch.  I did contact him and ask for his permission to use him as an example though.

The main part of Mr. Chartrand’s job is that he dresses as Superman, hangs around at Cardinals games and collects tips for posing in pictures with  fans and tourists.  He’s also been performing at birthday parties.   If you think there’s no money in this, think again, he can earn as much as $400 in tips in a day.    And that’s why he’s going to need to figure out his deductions before he files his tax return.

So what can Superman deduct?  Let’s hit the obvious thing first:  the costume–all of it.  Cleaning, repairing, replacing, clearly this is one clothing expense that will count as a business expense.  I would also include his undergarmets.  You can’t dress as Superman and wear any old boxer shorts.

The hair:  most of the time hair cuts and styling products, etc are not considered legitimate expenses for business, even if you are a professional actor or television personality.  In Superman’s case here, I would claim his hair expenses.  He has to dye his hair black to be Superman, and he uses four different products to get just the right effect–including the “S” shaped curl on his forehead.  I think that goes far beyond what would be normal for Mr. Chartrand during his off duty hours.  

I can’t tell from the photo if Superman is wearing make-up or not.   He doesn’t look like it, but if he was, I’d allow it.  (He might need to darken his eyebrows to match his hair.)    A note about make-up:  generally, make up is frowned upon by the IRS as a business expense.  A clown wearing clown make-up would qualify for a deduction, but most women in any business would not.  I once helped a dancer with her return and as we went through her expenses she claimed “a gallon of eyelash glue.”  Now, I thought that was an excessive amount even for a professional dancer.  “Not for eyelashes,” she said, “It’s to keep my costume on!”  Evidently, during a dress rehearsal she had had a “wardrobe malfunction”.  In order to keep herself looking decent, she glued her costume on to make sure she stayed covered.  That clearly fit the category of “necessary” and I put it in.  (Even the meanest IRS agent couldn’t argue that one.)

Let’s get back to Superman,  He can probably claim either a home office deduction or rent for his work space.  And, since he travels from his home office to his gigs, he can deduct his mileage as well.  These are expenses that are pretty normal for many small businesses.  It’s important to remember that even unusual businesses have normal types of expenses.  Another normal type of expense for Superman might be advertising, if he has flyers or cards that he distributes to get new business.

Here’s another expense that I would use for Superman that might seem out of the ordinary:  comic books—Mr Chartrand uses comic books to compare against his costume and maintain the authenticity of his look.  I’d count it as a valid business expense. 

Also, Mr. Chartrand has a goal of moving to Los Angeles.  Making a permanent move to Los Angeles would count as a moving expense, as opposed to a business expense.  But, if Mr. Chartrand makes a trip to Los Angeles, to test the market so to speak, he could probably write off most of that stay as a business deduction.  This would give him a chance to test out the market and give himself an out to come home if he found Los Angeles wasn’t the place for him. 

When claiming business deductions, the key phrase the IRS uses is “ordinary and necessary”.  

To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that is helpful and appropriate for your business. An expense does not have to be indispensable to be considered necessary.

When you’ve got a one-of-a- kind type of career, it’s not always easy to figure out what ordinary means.  Hopefully, Superman’s example can give you some ideas about what’s ordinary and necessary for your business.

To read more about Charlee Chartrand, aka Superman, this link will take you to the St. Louis Post-Dispatch article about him:

Superman Story

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