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A hobby deduction?

(Netfolio) -- Trying to deduct expenses related to a sideline venture can trigger an audit if you fail to meet IRS guidelines. With smart planning, however, your income-producing enterprise can reduce your overall tax bill.

Netfolio Insights asked William R. Fleming of PricewaterhouseCoopers LLP to spell out the rules:

1. Make sure your venture makes money

Before the IRS will allow you to deduct a sideline business, you must clear its "hobby loss" hurdle.

In short, the IRS knows that many people try to deduct hobbies that don't generate income, either purposefully or inadvertently. As a result, the IRS is prepared to deem a venture a hobby, not a business, if the venture fails to make a profit for three out of five years. People who breed, train, show or race thoroughbred horses must show a profit in two out of seven years.

If the IRS concludes that your venture isn't a money-making enterprise, you cannot deduct expenses or losses. In other words, you can deduct expenses related to a venture only when it operates as a business and isn't really a hobby.

2. Watch those tricky IRS rules

The IRS also will not allow you to deduct expenses that exceed the amount of income your venture produced if it is a "hobby."

If your venture is close to profitable, fine-tune your income and expenses so that you pass the IRS test. For example, if the enterprise is profitable this year and you need a new computer or camera, postponing the purchase until next year will let you show a profit this year and pass the IRS test.

If you're audited, you must demonstrate a clear intention to make a profit-even if your bottom line is not yet in the black.

The IRS measures "business intent" by using the guidelines mentioned below. The more guidelines you meet, the stronger your case that the activity is a business, not a hobby:

3. Show you're an efficient manager

Save receipts, run all business income and expenses through a separate bank account, pay your business expenses by check, print business cards and stationery, keep adequate books and records, and consider setting up a Limited Liability Company.

Even better, write a business plan that forecasts revenues and potential profits, and justifies your business strategies.

4. Consult with business professionals

When you have little knowledge of the enterprise you're engaged in, consult experts or buy books and take classes to make yourself an expert. Or hire knowledgeable advisors to assist you in running the venture. Both will show you're serious about your enterprise and that it's not a mere pastime.

5. Document time spent on the venture

If you hold a full-time job, how much time do you spend there relative to time spent on your part-time venture? The more time you spend on a sideline business, the better. A good rule of thumb is 500 hours. Use a calendar or day planner to document the time spent on your venture.

For example, most sideline ventures don't become profitable for years because of huge marketing and sales expenses. But a big payroll and a group of employees working around the clock prove that they are businesses, not hobbies.

6. Produce a plan to become profitable

If your venture is unprofitable at this point, you will need to show that the enterprise is close to making money when it appreciates or its assets are sold. The IRS likes to see a target date in the future when profits will occur.

7. Show that past ventures made money

Have you started or run similar activities in the past that were profitable? The IRS wants to see that what you're doing now stands a good chance of making taxable profits. Gather prior tax filings, books, etc. in case you have to prove your track record to the IRS.

8. Keep careful profit-loss records

The IRS wants to see that your venture has a history of profit-loss activity. Such activity shows that you're trying to make a go of it. The IRS will dig further when a venture has sustained high expenses that are not related to startup costs. These expenses show that a profit motive is lacking. Another IRS red flag is an extended period of low revenues without an explaination.

9. Get your profits-expenses ratio right

Substantial occasional revenue combined with low expenses demonstrate a profit motive. Conversely, small revenue combined with large operating expenses indicate your venture is a hobby and not deductible.

10. Show that your venture-income is high

Is your venture a major source of your total annual income? Running an enterprise that generates big tax breaks can indicate a lack of profit motive when you earn substantial income from other sources.

The greater the percentage of income from the activity relative to your other income, the more likely the IRS is to allow your deductions.

11. Don't have too much fun

Enterprises that are pleasurable are more likely to be considered hobbies than businesses. For example, a retired Navy captain took many cruises, where he videotaped the activities, intending to sell copies to the cruise participants. His gross receipts never exceeded $2,000 a year while his expenses increased over time. Overall, his "business" lost between $3,000 and $25,000 a year. As a result, the IRS didn't allow him to deduct his venture's losses or expenses because expenses in excess of income is not allowed.

However, having fun does not always lead to a determination that your venture is a hobby. For example, the IRS allowed an artist to deduct losses in 10 consecutive years, despite the pleasure she derived from her artwork. That's because her pleasure was not inconsistent with her demonstrated profit motive.

12. Know the penalties and the taxes on gains

Stiff penalties are levied when the IRS deems your venture is a hobby, not a business.

And remember, if you collect coins, stamps or other items as a hobby, you must pay capital gains tax when you sell an item in the collection at profit. If you've held the investment for less than a year, the gain will be taxed at your regular income tax rate. If you've held the investment for longer than a year, the gain will be taxed at the long-term rate.

When you sell collectibles at a loss, however, you can deduct the loss-first against other capital assets and then against other income. The maximum loss you can deduct against other income is $3,000 per year. The collectible must be a capital asset, not a personal asset.

However, you can offset the loss from the sale of one item against gains from sales of similar items in the same year. For example, if you sold two coins at a loss in 2000, consider selling one or more coins this year at a profit to absorb the loss.

(c) 2001 Netfolio

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