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Schedule C CPA discusses Hobby Income vs. Business Income| Form 5213 Election

Wilmington NC CPA and tax accountant

Gary Bode, CPA: hobby income is a hot topic now that the economy’s improving.. For a free phone consult, please call 399-2705.

In tough times, Americans do what America is known for – starting companies. Sometimes this happens accidentally, when a hobbyist, say a candle maker, makes that first sale. And even that first sale is taxable income to the IRS. In my experience as a Schedule C CPA, most folks understand this and voluntarily comply, even when the IRS isn’t likely to find out otherwise.

“You have an obligation to report income to the IRS and the right to deduct legitimate expenses.”
– Gary Bode, CPA

What about the $400 Threshold? 

The IRS requires you to report all income. The infamous $400 threshold only applies to self-employment tax, not income tax. That is, you do not need to pay self-employment tax until you have made at least $400.

You can be a LLC and still use Schedule C to report your taxes

  • A LLC isn’t an IRS designation. You set it up with your State.
    • If there is only one LLC member you can file the LLC’s tax return using Schedule C on Form 1040. There are two advantages.
      • The LLC legally insulates you personally from a law suit.
        • So if the LLC is sued the case can’t attach to your personal assets.
        • That being said a lawyer can “pierce” the LLC veil if the LLC isn’t managed right.
  • Schedule C is easier to prepare than a Partnership return (Form 1065) or a S Corporation (Form 1120).

The down side of Schedule C? The IRS states Schedule C tax audits greatly exceed Form 1065 and Form 1120 audits.

Can Becoming an S Corporation Overcome Hobby Income Limitations?

The IRS sees an S Corporation as being more professional than a Schedule C filer. While they specifically say being an S Corporation won’t protect you from the hobby income rules, it could be one factor in their decision, if you’re audited. As we’ll see below, there are a range of issues the IRS uses to decide whether you have hobby income or business income.

What is Hobby Income?

Simplistically, if you lose money three years out of five, it’s a hobby not a business. Of course there are IRS wrinkles. The IRS has a list of business ventures they often find to be hobbies. Arts and crafts, for example.

What are the Consequences of Hobby Income?

You can only write off expenses until hobby income is zero. You generally can’t claim a loss. Again, there are IRS wrinkles. For example, the expenses become itemized deductions, reported on Schedule A. This means:

  • Your expenses have to exceed 2% of Adjusted Gross Income.
  • Your total itemized deductions have to exceed the standard deduction to cut your tax liability.

In both cases, you generally have to have more expenses than income just to break even on your taxes!

Business Income

If you run a legitimate business (see below for the IRS parameters), you can deduct most expenses, even if they generate a loss in some years.

So how does the IRS Determine If  You Have a Hobby or a Business?

It depends. Every case is different.

  • 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 did they occur in the start-up phase 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?

Can the IRS Catch Hobby Income Disguised as a Business?

Sure, computer technology makes that easy. But they have limited resources and can’t follow up on every case.

What is the Form 5213 Election?

You can ask the IRS to wait on classifying you as a hobbyist. Some folks think this needlessly alerts the IRS. Others think it doesn’t really matter anymore given current IRS capabilities.

I’m a Schedule C CPA firm with a Virtual Office to serve long distance and international clients. Please read some of our postings to help gauge our expertise and proactive attitude. For a free phone consult call (910) 399-2705.

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2 comments to Schedule C CPA discusses Hobby Income vs. Business Income| Form 5213 Election

  • Gary scott

    I purchased a farm in 2012 that had been vacant for 4 years, working outside of the home and looking for ways to produce income off the property I invested in beef cattle. Starting out small as the upfront start up costs for this type of operation are extremely expensive. When completing income taxes this year I claimed the first year of start up losses. My plans are to continue to invest off farm income over the next several years to continue to grow the operation plus breeding of my livestock. Working the numbers considering the very large capital investment required and time to reach this goal my concern is being profitable 5 out of seven years. If I pour large amounts of my of farm income and any sales income back into the business to grow it to a pint that allows me to reach herd size and long term profitability I see that I could possibly not meet that irs standard. Any advice? Do I file for the extension 5213 at the beginning of the operation or wait until the third year? How does anyone afford to start up a farming operation unless they inherited a tenth generation family farm that is currently profitable? The huge upfront cost of this type of start up make it very difficult to meet the irs requirements unless I take in huge debts right if the bat. I am hoping to keep debt down and grow very slow over time hoping to turn my first profit year in my third or fourth year of operation.

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