ROANOKE TIMES
Copyright (c) 1996, Roanoke Times
DATE: Monday, July 1, 1996 TAG: 9607010015
SECTION: MONEY PAGE: 6 EDITION: METRO
SOURCE: MAG POFF STAFF WRITER
WHEN you think about it, said Mary Ann McElmurray, a lot of people do things on the side that they might develop into a business and a second income.
McElmurray, a certified public accountant with the Roanoke firm of Brown, Edwards & Co., said a walk through Roanoke's City Market illustrates her point. The stalls there are filled with people who have turned crafts into small businesses. As an example, she cited a craftsman who weaves articles from natural vines.
Other people give piano or art lessons, consult about wedding ceremonies or raise and sell puppies, she pointed out.
No matter what interest you pursue outside your regular job, she said, you might be able to turn a favorite hobby into a business. And there are tax advantages to being a business.
Yes, you have to pay income and other taxes, but McElmurray said you must declare any income you receive even if you don't have a business. The law requires you to tell the IRS about the money you received for the Himalayan kittens you sold even if you bred them as a hobby.
So, a major tax advantage of transforming your hobby into a business is the ability to deduct losses.
If you spend money on your hobby and incur a loss, she pointed out, the hobby loss cannot be used to slash your tax bill. But if you convert your hobby into a business which then suffers a loss, that loss is deductible against regular income. That includes the income you earn elsewhere, such as the salary from your regular job.
In addition to the losses, there's the matter of expenses.
If you buy a kiln for your pottery-making hobby, that cost is considered a nondeductible personal expense.
Tax deductions for hobby expenditures are allowed for expenses that would be tax deductible regardless of whether or not the hobby existed such as taxes and certain types of interest. In addition, such deductions attributed to the activity are allowable only to the extent of the gross income derived from the hobby.
However, when you make a profit from a hobby, you must claim the full amount as income.
In contrast, when you run a business, you can offset your taxable income by deducting the full amount of your business expenses on Schedule C. (The exception for any business is that meal and entertainment expenses are only 50 percent deductible.)
But McElmurray warned that you "walk a fine line between a profit-making business" or something called a hobby.
The test of the Internal Revenue Service is whether the venture has been profitable in three of the last five consecutive years. An exception to that rule concerns horses. Whether breeding, training, showing or racing, the profit presumption applies if you show a profit in only two of the last seven years.
If you don't pass the three-years-out-of-five rule after three years, and the IRS challenges the business status of the activity, you can get a waiver. You can file IRS Form 5213, which asks for a postponement of a determination until the full five years have passed.
If you file for a waiver, you will have extra time to prove that you are in business. During that time, moreover, you can claim business deductions. But there is a danger: you will owe back taxes and penalties if your activity fails to qualify as a business at the end of the five-year period.
Running a small business instead of engaging in a hobby can have some perks, McElmurray pointed out.
Say you turn your hobby of photography into a business and become a part-time professional photographer. If you travel to a resort location for a business assignment, she said, you should be able to deduct expenses for the trip, in essence subsidized by the IRS.
You might also belong to a trade group, and McElmurray pointed out that such organizations usually hold conventions in desirable locations. Expenses of travel to a trade show or convention related to your business may also be deductible. That factor, McElmurray said, "keeps Disney World going."
The Virginia Society of Certified Public Accountants warned that the Internal Revenue Service is suspicious of business deductions claimed for hobbylike activities, so you can expect the agency to scrutinize deductions for potentially unreasonable business, travel and entertainment expenses.
To protect your business and your deductions, the society said, you should be sure to maintain your books in a businesslike manner and keep meticulous records that document the place and purpose of all business expenses.
It's also important to have a separate checking account for the business.
Remember also that you may qualify for other tax breaks for your business such as deductions for contributions to a retirement plan, home office expenses and business equipment leasing.
On the other side, you have to file estimated taxes and self-employment taxes.
Turning a hobby into a business can be fun because you enjoy the activity in addition to getting tax breaks, McElmurray said. It gives you "pay for play."
LENGTH: Medium: 93 lines ILLUSTRATION: GRAPHIC: color.by CNB