Many snow and ice management businesses are feeling the impact of the Coronavirus pandemic and/or concerned about the future of their business. Not too surprisingly, many contractors and other business owners are considering branching out into another field. Beware, however, the tax laws and the IRS’s auditors can trip up the unwary.
Whether to cash-in on a hobby, create a second source of income, or to plan for retirement, more and more snow and ice removal business owners are looking at secondary activities. Not too surprisingly not only will our tax laws partially underwrite those activities; the almost inevitable losses can be as beneficial as extra income. But, not always.
CASHING IN ON A SECONDARY ACTIVITY
It is not unusual for a small business owner to have multiple businesses. In fact, it is quite common in today’s tough economy, more and more people are using – or forced to use – their hobbies, sports, or secondary interests to generate income.
In the past, the losses from a secondary or hobby-related activity were treated as a tax shelter, offsetting taxable income from the primary source of income. Today, those secondary activities are often needed to produce badly needed income rather than losses. Not too, surprisingly, Uncle Sam, in the form of our tax laws, can help or hinder.
HOBBIES AND HOBBY BUSINESSES
Under our federal income tax laws, all income from whatever source is taxable. That means all income from a hobby activity such as dog-breeding or showing, boat charters, racing cars, farming, or other hobby-related activities are taxable. Fortunately, the expenses of that activity may be used to offset the income of even hobbies.
With an activity that is a hobby, that is an activity not engaged in for profit, the expenses are generally deductible only to the extent of income produced by the activity. Naturally, some expenses are tax deductible whether or not they are incurred in connection with a hobby, such as taxes, interest and casualty losses.
However, if the activity is engaged in for profit, not if it made a profit but, rather, that it is operated with the “intent” of making a profit, many activity-related expenses are legitimately deductible – even if they exceed the income from that activity. The amount by which a hobby or secondary business’s expenses exceed its income, its losses, can offset all income from other sources.
The general rule is that an activity is presumed not to be a hobby if profits (more income than expenses) result in any three of five consecutive tax years ending with the tax year in question. An activity involving the breeding, training, showing, or racing of horses is presumed not to be a hobby if profits result in two out of seven consecutive years.
Fortunately, there is more than one way in which to label an activity as a business. Without profitable years, anyone operating a secondary business activity can, if asked, prove the intent to show a profit using guidelines established by the courts and that are now accepted by the IRS.
Generally, the ordinary and necessary expenses of carrying on a trade or business are tax deductible. Funny thing though, if there is no business there can be no tax deductions for business expenses. Don’t despair because special rules exist for the expenses incurred in starting a business.
Anyone who pays or incurs business start-up costs and who subsequently enters the trade or business can choose to expense and immediately write-off up to $5,000 of those costs. Of course, the $5,000 deduction amount must be reduced, dollar-for-dollar when the start-up expenses exceed $50,000.
The balance of start-up expenses, if any, are to be amortized (written-off) over a period of not less than 180 months, starting with the month in which the business begins.
HOME OFFICES, STUDIOS AND SHOPS
The operator of a business, even someone with only the “intent” to show a profit from his or her activities, is entitled to a tax deduction for the expense of maintaining an office, shop or studio at home. Naturally, a deduction for the expenses of using a home for business purposes cannot be claimed unless the expenses are attributable to a portion of the home (or separate structure) used exclusively on a regular basis.
The home workspace is also deductible if used as the principal place of a business, as a place of business that is used by patients, clients or customers in meeting or dealing with the activity’s operator in the normal course of business; or in connection with the activity or business if a separate structure that is appurtenant to, but not attached to the home.
Generally, a specific portion of the house must be used solely for the purpose of carrying on a trade or business in order to satisfy the exclusive use test. The phrase “principal place of business,” includes a place of business that is used for administrative or management activities.
A word of warning: the home-office deduction cannot exceed the gross income from the activity, reduced by the home expenses that would be deductible in the absence of any business use (mortgage, interest, property taxes, etc.,) and the business expenses not related to the use of the home.
INTANGIBLE STILL DEDUCTIBLE
Often overlooked by many are tax deductions for the secondary operation’s “intangible” assets. The purchase of a going business usually includes “goodwill,” an intangible asset that, because it was purchased, can be amortized over a 15-year period. An intangible business asset that does not qualify as purchased or acquired may be amortized generally using the straight-line method, provided it has an ascertainable value and useful life that can be measured with reasonable accuracy.
A TRAP FOR THE UNWARY
Our voluminous tax rules limit the deduction for losses from so-called “passive activities.” Generally, losses from passive activities may not be deducted from non-passive income (for example, wages, interest, dividends – or profits – from the principal business).
A passive activity is one that involves the conduct of any trade or business in which the taxpayer does not materially participate. Materially participating can be measured in a number of ways including putting in more than 500 hours each year. Materially participating also occurs when the individual’s participation constitutes substantially all of the participation in the activity.
The IRS can both tax and help underwrite a secondary, part- or spare-time activity. On the one hand, they stand ready to tax all of the activity’s income. On the other hand, many of the activity’s expenses may be used to offset “hobby” income. Operate the activity as a “business,” however, and the amount by which the activity’s expenses exceed its income, the “losses,” can be used to offset income from other sources, such as a professional snow and ice management business. Will your hobby or secondary business generate tax losses or badly-needed extra income?