Are you a hobbyist? In my previous article I shared some ways you can turn your hobby into a tax-deductible business. The four ways were:

1. Keep accurate records
2. Three in five profit ratio
3. Plan when you spend and get paid
4. Draw up a business plan
Here are some other things you ought to do:

5. Carry out your hobby/business full-time
The IRS flags anyone who claims expense deductions from a hobby against his or her 40-hour a week day job income. Here is a fact – the IRS considers what you do full-time as your vocation, so if you want to silence all questions from the IRS, consider carrying out your hobby as a full-time business.

6. Claim your deductions against business income
Remember the 3 in 5 profit ratio? If you can generate more income than expenses and offset those expenses from your income, then the IRS would more likely see your hobby as a business even though you carry it out part-time. So the key to achieving this is to make a net profit so that you do not claim expense deductions against your day job taxable salary.

7. Delay a profits determination
In order to show a profit, you can avail yourself to the special tax rule that allows you to defer the determination of profit motive until the fourth year of your business (or sixth year in the case of horse breeding). This will postpone the determination of whether you have met the three in five years profit presumption. The idea of the election is to give you time to ramp up and achieve a profit.

However, this may invite an audit by the IRS and may extend the statute of limitations beyond the normal three years so the IRS has a right to examine all the years in question after the deferral period has passed.

8. Hire expert help
If you can hire experts to help you in your hobby/business, it gives it a more business-like character. Alternatively, you could do extensive research yourself and keep good records of it so that you can show the IRS the amount of work you have done in becoming competent in your hobby/business.

9. Combine related activities
If you are involved in activities that are related to your hobby/business, you can combine their profits or losses together on a single Schedule C and make it more likely to show a combined profit three years out of five. For example, if you are a betta fish hobbyist who sells pet betta and you start another part-time business providing aquarium pumps, then you can legitimately combine these two activities and consider them one single business.

These are 9 ways to make your part-time hobby into a business that would satisfy the IRS and allow you to make expense related expense deductions when you file your taxes.

Can you claim deductible expenses from your hobby? You can if you make your hobby become your business. If you are spending a substantial amount of money on your hobby, you might as well turn it into a business. Look at it this way – suppose you spend $20,000 a year in your hobby, then you can report that loss on a Schedule C and write if off against your salary on your Form 1040. Assuming your combined state and federal income tax rate is 40%, maintaining your hobby will really only cost you $12,000, and the federal and state governments would have subsidized your hobby. Doesn’t that sound appealing?

However, this is only possible if you turn your hobby into a business. If you don’t, you are not allowed to claim a loss from it. But you must still report any income from any sales, but you can only deduct your expenses from your hobby to the extent of those sales. Moreover those expenses must be claimed as miscellaneous itemized deductions, provided they exceed 2% of your adjusted gross income.

So it does make sense to turn your hobby into a business. Here’s how to do it.

1. Keep accurate records
As in any business, record-keeping is a must. So you must make sure you keep accurate records of all your transactions (sales, expenses etc) relating to your hobby. This is a standard requirement whether or not you are making a profit.

2. Three in five profit ratio
The golden standard in the eyes of the government is making profit 3 years out of every 5 (if you hobby is horse breeding, the ratio falls to 2 out of 7 years). This gives your hobby the credibility to be considered a legitimate business. If you achieve this, then even if the IRS argues that your hobby is not a business, the onus is on them to prove otherwise.

3. Plan when you spend and get paid
To achieve the three in five profit ratio, you should make wise choices in how and when you spend money on your hobby/business. You can increase the expenses by lumping together similar expenses (for example by buying all your equipment in one year); likewise you can decrease your expenses by spreading them out over different years. Similarly, you can control your income to some extent (although this is more difficult than controlling your expenses). You could bill your customers at certain times to time your income just the way you want it. All these go towards achieving that 3 years profit out of 5 that the government wants to see.

4. Draw up a business plan
Make your hobby look business-like by coming up with a simple business plan. It does not matter if you stick to it, just have it available so that you can produce it to IRS agents if they come calling. Periodically revise your business plan so that it looks legit.

In the second part of this article, I will share more ways you can turn your hobby into a tax deductible business.

Having children can help you to save on your taxes. The IRS has just revealed the ten tax benefits you can have when you have kids.

1. The most obvious tax benefit in having children is being able to claim dependency deductions. Most of the time, a child can be claimed as a dependent in the year they were born. For more information see IRS Publication 501, Exemptions, Standard Deduction, and Filing Information.

2. You can claim Child Tax credit for each of your children so long as they are below 17 years of age. If you do not benefit from the full amount of the Child Tax Credit, you may be eligible for the Additional Child Tax Credit. For more information see IRS Publication 972, Child Tax Credit.

3. If you hire someone to care for your children under 13 years of age while you go to work (or look for a job), you may be able to claim the Child and Dependent Care Credit. IRS Publication 503, Child and Dependent Care Expenses covers this provision.

4. If you incur expenses adopting a child, you may be eligible to claim for the Adoption Credit. In order to claim the Adoption Credit, you must file a paper tax return with required adoption-related documents. For details, see the instructions for IRS Form 8839, Qualified Adoption Expenses.

5. You can deduct insurance premiums that cover your child under 27 years of age if you are self-employed and pay for your own health insurance, even if your child is no longer your dependent.

6. Do you have children pursuing higher education? You may be able to claim Higher Education credits such as the American Opportunity credit and the Lifetime Learning credit that can offset your child’s higher education fees. Some credits (like the two mentioned above) are dollar-for-dollar credits, meaning they reduce your expenses by the exact amount.

7. If you have an outstanding student loan, you may be able to deduct the interest paid on a student loan that qualifies for deduction. This is possible even if you do not itemize your deductions. See IRS Publication 970, Tax Benefits for Education for more information on the Higher Education credits.

8. If you are a wage-earner, self-employed or do farming, you can claim the Earned Income Tax Credit (EITC). This credit reduces your tax liability and may even give you a refund and is applicable whether or not you have children. For more information, check out IRS Publication 596, Earned Income Credit.

An IRS audit is the thing most taxpayers are afraid of. But most of this fear comes from not knowing what an audit is all about, what it entails and most of all, what to do when you receive and audit notice. So if you know a few basic things about the whole matter, it takes a lot of fear out of it. Receiving an audit notice does not mean that you have committed an offence. In fact, audits can result in acceptance of the tax return without change or even a refund. If that be the case, how does the IRS choose who to audit in the first place?
There are several factors that govern who the IRS chooses to audit. Firstly, some tax returns are chosen for audit through the screening of a computer. An IRS computer compares data from a return to average numbers from other people’s tax returns in similar situations looking for variances. The data that is reviewed by the computer are things like charitable donations, interest income and variations from averages in your income bracket or zip code. If a major variance is detected, that tax return is chosen for audit.

Secondly, tax returns are chosen for audit based on comparisons with other documents like your W2s. The computer sees if your tax return matches up with your W2 and if there is a mismatch, that return is called for audit.

Thirdly, there is the category called “related examinations”. This is where returns may be selected for audit when they involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for audit. And finally, some returns are selected for audit purely at random.

Most taxpayers would not face an audit their entire lives. According to IRS statistics, those earning below $200,000 per year had only a 1% chance of being chosen for audit whereas the rate of audit for those earning above $1 million a year was about 12.5%. All in all in 2010, the IRS audited nearly 1.6 million individual returns, slightly more than 1% of the total filed. Most of the audits were conducted via letters, and others through field examinations by an IRS agent. If your tax return is chosen for audit, you will be notified via a phone call or snail mail, never via email.

Some of the more common people called for audits are those that make charitable contributions, those earning cash income (like waitresses or bellboys) and those claiming deductions from a home office.

The best defense in an audit is accurate documentation. It is important for you to think through those items reported by third parties and make sure you have the documentation that matches up with them. And you should always have copies of your expenses and official receipts. If these are in order, you should have no fear of an audit.

What if You Face the IRS in Court

If you have to face the IRS in court, would you know how to defend your case? Preparation is the key, but preparation depends on what your case would be about. Another important factor is whether you have a lawyer represent you or you choose to represent yourself. Taxpayers who choose a lawyer to represent them in cases of dispute with the IRS are successful 58% of the time whereas those who represent themselves are successful only 34% of the time. There are a slew of cases that taxpayers and the IRS most frequently contend over in court. Here are some of them and how you can deal with them.

1. Deductible expenses
Among the most frequent sources of contention between the IRS and individual taxpayers is expenses allowed for deduction. This means you deduct certain business expenses that the IRS deems not a business. You will likely receive an audit notice in such a case. This has been most common among animal related businesses as the IRS often sees the animals as pets and the business as a hobby rather than a genuine business. This is especially so if you report the business as a loss making one.

Therefore if you run a loss-making business and you wish to claim deductions on business expenses, you would do well to get the professional opinion of a tax attorney on your case.

2. Non-taxable income
Another frequent source of contention in court between the IRS and taxpayers is what amounts to non-taxable income. Fixed and regular wages, fees, salaries etc are very straightforward. But the contention arises when it comes to things like damages awarded by a court or discharges of debts. Generally, court-ordered damages due to physical injury or sickness are not taxable but other damage payments like damages for emotional distress are. So the best thing to do is to clearly state what the damages are for and have a tax attorney review the final settlement to advice you on how to successfully classify your damages as non-taxable income.

Likewise, when it comes to discharge of debts such as a housing loan debt, it is better to seek proper legal counsel from a tax attorney to find out if your discharge can be tax exempt.

3. Innocent spouse issues
The question of whether an innocent spouse was ignorant of the offending spouse’s tax transgressions is another common contentious issue. A spouse is an innocent spouse if there was genuine ignorance. Again, the best route to take in determining this is to hire a tax attorney to review your case.

4. Contributions to charities
This is quite a new type of contention that has been getting more prevalent lately. To determine if the charity you contributed to is a qualified tax-exempt charity is easy but issues arise when determining the value of your contribution if it is in kind. The key here is to obtain official and legitimate valuation of your contribution in kind to any tax-exempt charity.

If you are facing issues with the IRS over some disputed taxes, we are here to help. Call us at (813) 229 7100 for a free consultation.