ROANOKE TIMES
Copyright (c) 1997, Roanoke Times
DATE: Monday, February 10, 1997 TAG: 9702120017
SECTION: BUSINESS PAGE: 6 EDITION: METRO
COLUMN: TAX QUESTIONS
Q: On Sept. 26, 1996, I started my own home business wherein I became a marketing consultant. To date, I have been unsuccessful in developing clients and continue to solicit my services in an effort to secure my first account.
Since opening my office at home, I have invested several thousand dollars in computer hardware and office furniture, all of which was purchased in 1996.
My questions are:
1. Can I wait until 1997 taxes are due to write off my 1996 and 1997 expenses associated with my new business?
2. If I take the write-off on business expenses in 1996 or 1997 and I am not able to produce a profit in the required time allowed, are there penalties against me or my business? If so, please elaborate on these penalties as much as possible.
3. Since my existing income is from retirement funds, would I use this income to deduct my business expenses or would deductions apply only against income from my new business?
A: Assuming that you are a cash-basis taxpayer and assuming that you became "actively engaged" in your new business in 1996, then your 1996 and 1997 noncapitalizable operating expenses must be deducted in the tax years in which they are paid.
The 1996 computer and office furniture purchases must be capitalized and deducted via depreciation over five and seven years, respectively.
If a deferral of the 1996 expenses is desirable - and it sounds as if it is in this case since there is apparently no gross income from the new business in 1996 - these depreciation deductions could be effectively deferred until 1997 by electing Section 179 expensing. The Section 179 deduction (up to a maximum of $17,500 for 1996) will be deductible to the extent of net income in subsequent years.
Some of the 1996 expenses might also have to be deferred until 1997 or later as Section 195 "start-up" expenses or as a carryover of "home office" deductions due to net income limitations.
"Start-up" expenses are preopening type expenses incurred in investigation or creation of an active trade or business or in anticipation of the start of a business. These must be capitalized but can be amortized over a 60-month period if a timely election is made on the tax return.
In addition, the facts indicate that you will have to comply with the "home office" rules. Recent judicial and statutory developments and the general complexity inherent in these rules preclude an adequate discussion of this issue in this forum.
As to question two, the law does not directly impose any time limitations for a new business to begin to report profits. Accordingly, there are no penalties directly associated with such limitations.
What you are probably referring to are the "hobby loss" rules under Section 183 of the Internal Revenue Code.
These rules generally operate to disallow losses, usually ongoing, from "activities not engaged in for profit."
Typically, this rule is imposed by the IRS to activities that possess a high element of personal pleasure and/or recreation - examples are "gentleman" farming, horse and dog breeding, auto racing, arts and crafts, etc. - and where there is a history of ongoing losses, minimal revenue and significant amounts of income from other sources on the part of the taxpayer.
The law does provide a rebuttable presumption that states that such an activity may be presumed to be "for profit" if the activity shows net income for three out of five consecutive tax years (two of seven years for horse racing, breeding or showing).
"Rebuttable presumption" means the IRS can still challenge and win a hobby loss case even where the activity has occasionally reported profits.
As for penalties, if the IRS disallows losses under this hobby loss rule, the taxpayer would generally only be liable for late payment penalties and interest associated with the resulting income tax deficiency.
In addition to the ones mentioned above, some of the other key factors that the IRS will consider in making a determination under the hobby loss rules are:
1. The taxpayer's history of income and losses with respect to the activity.
2. The financial status of the taxpayer.
3. The time and effort expended by the taxpayer in carrying on the activity.
4. The manner in which the taxpayer carries on the activity.
5. Books and records, or the lack thereof, maintained for the activity.
6. The cause of the losses.
7. The expertise of the taxpayer or his advisors.
8. The expectation of profit by the taxpayer.
In this case, if the retirement income is substantial and the consulting business shows little or minimal gross income for several years, I suggest that good records be kept as to the taxpayer's efforts and time expended and that the business be operated in the same manner as would reasonably be expected of someone who expects to make a profit in a similar venture.
As for the third question, except for the "home office" and Section 179 expensing limitations previously mentioned, the losses from your consulting business will be deductible against all other income, including your retirement income.
- Answered by Mark F. Coles of H. Schwarz & Co.
LENGTH: Medium: 96 linesby CNB