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Columns by June Walker: IPs Face Unique Tax Challenges Tax Deductions Are There For The Taking You Say You're Self-Employed -- Will the IRS? Criteria for Self-Employment Do You Have a Business or a Hobby? Proving That You're a Business Keeping Records -- It's Not Just for Taxes Three Ways to Expand Your Business Deductions Can I Deduct Disneyland and Other Questions Mixing Business with Pleasure and Other Gray Areas Quicken for IPs Courses That Qualify Training You Can't Deduct Getting There is Half the Battle Taking Deductions on the Road Getting Credit and Taking Allowances Advertising: Do It, Then Deduct It The Subtle Art of Advertising Deductions Billy Bridesnapper's Start-up Saga Starting Up and Shutting Down Start-Up Wrap-Up Giving Gifts, Taking Deductions

Do You Have a Business or a Hobby? There are two requirements to be met in order for the IRS to classify you as an independent contractor. As noted in earlier installments of this column, the first is establishing yourself as a self-employed person rather than as an employee. The second is that you must be engaged in a business. It can't be a hobby supported by Grandma's inheritance; it must be a real, honest-to-goodness business. Why would you want to be a business rather than a hobby? The answer has to do with -- what else? -- paying less taxes. So before checking out your business, let's look at a simple tax concept. Taxes as a Plus-Minus Formula Various types of income (or "plusses") come in to you. Examples: wages; pensions; savings account interest; stock sale gains; unemployment compensation; lottery winnings. You pay tax on your income. That's why it's called income tax. However, various kinds of deductions (or "minuses") can reduce your income. Examples: IRA contributions; stock sale losses; business organization or union dues; charitable contributions; mortgage interest; gambling expenses. You subtract the minuses from the plusses before you calculate the tax you owe. Therefore, the more minuses, the less tax you pay. If you are self-employed and your self-employed expenses are greater than your self-employed income, you will have a net loss from self-employment. That loss is subtracted from your other income (that is, from the part of your income that doesn't come from self-employment). Of course, the goal of being self-employed is to make money; but even losing money can be of some help -- it can help get those overall plusses down so that you pay less tax! However, if you lose money at self-employment, you are only allowed to deduct it from your other income if you're really in business. You're not allowed to deduct the loss if your "self-employment" is really a hobby. Remember there are two parts to the "I'm self-employed" proof. Even if you are very clearly not an employee, that still doesn't prove you are self-employed unless you can show that you're in it to make money. In order for you to be engaged in a business rather than a hobby the goal must be to make a profit! If your endeavor is not for the purpose of profit, any loss you incur from it may not be a minus against other income, and thus the deductions are limited. Aunt Annie lives nicely off the income generated from her investments. She enjoys quilting very much, and every once in a while an acquaintance or relative buys something she's made. Annie keeps no record of her expenses and does not advertise. She gives many of her quilts to her nieces. Based on these facts, Annie has a hobby. If she sells $1000 worth of quilted pillows in a year she is allowed to deduct only up to $1000 in quilting expenses, even if her costs were more than $1000. Why? Because hers is a hobby, not a business. $1000    gross quilting income minus $1000    allowed expenses* equals    $0    net income *even though she spent much more than this on a special cutting board   Jane Jeweler, unlike Aunt Annie, has no investments. To earn a living she must work as a W-2 person (a regular job) at a clothing store. Evenings and weekends she designs and makes silver jewelry. She can't keep up with the requests for her unique pieces. So she cuts back on the hours at her regular job to devote more time to designing, creating and selling her jewelry. She's not sure how long it will take, but she's determined to leave her regular job eventually and make a living as a jewelry designer. She was an excellent apprentice to a highly respected silversmith in her town and even helped him redesign his studio. She keeps careful records of how long it takes her to complete each piece, and bases her prices on her records and the going market rate. Based on these facts, Jane is a self-employed jeweler. She is in business -- even before she quits her regular job. If she sells $1000 worth of jewelry, she may deduct as many business expenses as she incurs even if they amount to many thousands of dollars. If Jane's net income is a loss, that loss can be deducted from her other income and could reduce her taxes. $1000    gross jewelry income minus $3000    expenses equals    -$2000    net income (said another way, Jane has a $2000 loss) The $2000 loss from the jewelry business would reduce her taxable W-2 wages from $20,000 down to $18,000.   By the way, in accounting, subtraction and negative numbers are indicated by (parentheses). For example, ($2000) means negative $2000 or subtract $2000 or a $2000 loss. Therefore the above example may be written as follows: $1000    gross income (3000)    expenses equals    $(2000)    net profit (loss) An activity is a business if its goal is to make a profit. If your activity always makes a profit: No problem, it's a business. If your activity makes a profit in 3 out of 5 years: no problem, it's a business. That's because, since 1987, the IRS presumes it to be a business if there is a profit in 3 out of 5 consecutive years (2 out of 7 for horse breeding, training, showing or racing). The profitable years do not have to be consecutive, but the five years during which they fall must be consecutive. Let's look at two examples, with bold type as a reminder of the 5 most recent consecutive years: A Business:   Not a Business:*   1993 Loss 1994 Loss 1995 Profit 1996 Loss 1997 Profit 1998 Profit 1999 Loss           1993 Profit 1994 Profit 1995 Profit 1996 Profit 1997 Loss 1998 Loss 1999 Loss *Because in the five most recent years there was a profit in only two.     But how do you prove you're doing something to make a profit if you're not making a profit? Pretty simple: you must show you have a profit motive. The IRS doesn't insist that you actually make a profit, but there must be a reasonable expectation of one. It could be: A big chance of making a small profit, or A small chance of making a big profit. Just as the IRS provides guidelines (the famous "20 factors") for determining whether you're really self-employed or an employee, it also provides guidelines for determining whether you're a business or a hobby. For both kinds of determinations, the IRS takes into account all the facts surrounding an activity in determining its status. There's no one simple "test" that will immediately nail it down. The next column in this series will help you determine -- in case you had doubts -- whether you're doing whatever you're doing to make a buck, and thereby qualify as a self-employed person who's really in business. (c) 2000 June Walker. All rights reserved. We'd love to hear your feedback about this column, or put you in touch with June Walker if you like. You may also like to see her biography.