Is it a business or a hobby for IRS Purposes?

What is a business for tax purposes? Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit. In order to make this determination, taxpayers should consider the following factors: Does the time and effort put into the activity indicate an intention to make a profit?

Does the taxpayer depend on income from the activity? If there are losses, are they due to circumstances beyond the taxpayer’s control; or do they occur in the startup days of the business? Has the taxpayer changed methods of operation to improve profitability? Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business? Has the taxpayer made a profit in similar activities in the past?

Does the activity make a profit in some years? Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity? The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current tax year.

 

Structures for Businesses

It is important that you choose the right kind of business structure for your venture. The most common ones are first, sole proprietorship. A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company, that’s LLC, you are not a sole proprietor if you elect to treat the LLC as a corporation. Next is partnership. A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.

A partnership must file an annual information return to report the income, deductions, gains, losses, et cetera, from its operations; but it does not pay income tax. Instead, it passes through any profits or losses to its partners. Each partner includes his or her share of the partnership income or loss on his or her tax return. Partners are not employees and should not be issued a Form W-2. The partnership must furnish copies of Schedule K-1, Form 1065, to the partners by the date Form 1065 is required to be filed, including extensions. Your business can also be a C Corporation. The profit of a corporation is taxed to the corporation when earned and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation. Generally, businesses need an Employer Identification Number, also known as a Federal Tax Identification Number. It is used to identify a business entity. You may apply for an EIN in various ways, including online at www.IRS.gov. The qualifying criteria for whether you need an EIN are listed on the website. The IRS.gov page is providing information on business structure, and also gives information on the Federal taxes that must be paid and the forms which must be filed with the IRS.

 

Do businesses owe tax?

The taxes your business may be subject to are: income tax, all businesses except partnership must file an annual income tax return. Partnerships file an information return. The form you use depends on how your business is organized, as we discussed in the Business Structure section earlier. Estimated tax – generally, you must pay taxes on income, including self-employment tax, by making regular payments of estimated tax during the year. Self-employment tax — self-employment tax, or SE tax, is a Social Security and Medicare tax, primarily for individuals who work for themselves. Your payments of SE tax contribute to your coverage under the Social Security system. Social Security coverage provides you with retirement benefits, disability benefits, survivor benefits, and hospital insurance, Medicare benefits. Employment taxes – when you have employees, you as the employer have certain employment tax responsibilities that you must pay and forms you must file. Employment taxes include the following: Social Security, Medicare taxes, Federal income tax withholding, and Federal unemployment or FUTA tax, excise tax. This section describes the excise taxes you have to pay and the forms you have to file if you do any of the following: manufacture or sell certain products; operate certain kinds of businesses; use various kinds of equipment, facilities or products; receive payment for certain services

 

Business Employment Taxes

Two of the major pitfalls for small business are poor recordkeeping and a failure to recognize all items that constitute gross receipts, otherwise known as taxable business income. We will also show several best practices that small businesses should use to avoid tax problems. They are: good recordkeeping, reporting all taxable income, separating business and personal expenses, making sure your returns are accurate, using eFile to increase filing accuracy and speed, choosing your preparer carefully, and finding out where you can go for IRS help. That’s a lot to cover, so let’s begin. The information being presented today can be found on the Starting a Business page on www.IRS.gov. We will go over some of the important issues that new business owners need to know. These issues include: is it a business or a hobby; selecting a business structure; employer identification number; understanding business taxes and recordkeeping requirements. All new businesses need to consider this threshold issue.

 

More on employment taxes

If you have employees working for you, you will be responsible to withhold and deposit Federal income taxes, Social Security taxes, and Medicare taxes. The funds that you withhold from your employees’ wages are referred to as trust funds since you are holding these monies in trust until you, the employer, deposit these monies into the Federal Deposit system. As an employer, you will also be responsible to report and deposit Federal unemployment tax, known as FUTA. As a business owner, it is important that you understand an employer’s responsibility of withholding, reporting timely, and adequately depositing all employment taxes. One of the employment taxes to withhold from your employees’ wages is income taxes. To figure how much to withhold from each wage payment, use the Employees Form W-4, Employees Withholding Allowance Certificate; and methods described in Publication 15, Employer’s Tax Guide, and Publication 15-A, Employer’s Supplemental Tax Guide.

Other employment taxes to withhold are the Social Security and Medicare taxes that pay for benefits that workers and families receive under the Federal Insurance Contributions Act, known as FICA. The total Social Security is 12.4% of wages, with the employer paying 6.2%, and the other 6.2% being withheld from the employee’s wages up to the Social Security wage base. The total Medicare tax is 2.9% of the wages, with the employer paying 1.45% and the remaining 1.45% withheld from the employee’s wages. There is no wage base limit for Medicare tax, so all covered wages are subject to Medicare tax. Small business employers often outsource some of their payroll and related tax duties to third-party payroll service providers. These services effectively streamline business operations; however, an employer’s use of a PSP does not relieve the employer from his responsibility of ensuring that all its Federal employment tax duties are met. A PSP assumes no liability for their employer/client’s employment tax withholding, reporting, payment, and/or filing duties. A payroll service provider typically prepares employment tax returns for signature by its employer/clients and processes the withholding, deposit, and payment of the associated employment taxes for its common law employer/clients.

Small Business Tax Reccordkeeping

Now let’s turn to one of the most important factors in your small business success, keeping and maintaining good records. Recordkeeping can help you in several ways. First, you need good records to monitor the progress of your business. Records can show whether your business is improving, which items are selling, or what changes you need to make. You also need good records to prepare accurate financial statements. These include any income statements which show the income and expenses of the business for a given period of time; and a balance sheet, which shows the assets, liabilities, and your equity in the business on a given date. These statements can help you in your dealings with your bank or your creditors and in managing your business. You will receive money or property from many sources. Your records can identify the source of your receipts. You need this information to separate business and non-business receipts and taxable from non-taxable income. Recordkeeping will also help you keep track of deductible expenses. You may forget expenses when you prepare your tax returns unless you record them when they occur. Of course you need good records to prepare your tax returns. Generally, these are the same records you use to monitor your business and prepare your financial statements. Finally, you must keep your business records available at all times for inspection by the IRS. If the IRS examines any of your tax returns, you may be asked to support the items reported. A complete set of records will help you explain the items you claim and speed up the examination

 

Keeping Track of Business Income and Expenses

Whether you use a system like this or an alternative system, you need to be aware of burden of proof. Burden of proof is the responsibility to prove entries, deductions and statements made on your tax returns. You must be able to prove certain elements of expenses to deduct them. Generally, taxpayers meet their burden of proof by having the information and receipts or sufficient evidence for the expenses. This substantiation includes receipts, canceled checks and bills. Additional evidence is required for travel, entertainment, gifts and auto expenses. The system you use to record business transactions will be more effective if you follow good recordkeeping practices. For example, record expenses when they occur and identify the source of recorded receipts. Generally, it is best to record transactions on a daily basis. For more information on recordkeeping and other small business topics, go to www.IRS.gov and enter “operating a business” in the Search box. As you can see, several major topics of interest are listed there. Clicking on these will link to further information, including forms, FAQs, and other resources to help you. One way to keep good records is to open a dedicated business bank account. You should keep your business account separate from your personal bank account.

 

Using a Business Checkbook

The business checkbook is your basic source of information for recording your business expenses. You should deposit all daily receipts in your business checking account. Consider using a checkbook that allows enough space to identify the source of the deposit as business income, personal funds, or loans. You should also note on the deposit slip the source of the deposit and keep copies of all slips. You should make all payments by check to document business expenses. Write checks payable to yourself only when making withdrawals from your business for personal use. Avoid writing checks payable to cash. If you must write a check for cash to pay a business expense, include the receipt for the cash payment in your records. If you cannot get a receipt for a cash payment, you should make an adequate explanation in your records at the time of payment. Use the business account for business purposes only. Indicate the source of deposits and the type of expense in the checkbook. Gross receipts are the income you receive from your business. Good recordkeeping also depends on you keeping supporting documents that show the amounts and sources of your receipts, such as cash register tapes, bank deposit slips, receipt books, invoices, credit card charge slips, and Forms 1099 Miscellaneous. Once your records are in place, make sure you report all of your taxable income to avoid tax trouble.