Avoiding Hobby-Loss Restrictions

Like many of us, you've probably dreamed of turning a hobby or avocation into a regular business. You won't have any unusual tax headaches if your new business is profitable. However, if the new business consistently generates losses (deductions exceed income), the IRS may step in and say it's a hobby (an activity not engaged in for profit) rather than a business.

What are the practical consequences? Under the so-called hobby loss rules, you'll be able to claim certain deductions that are available whether or not the business is engaged in for profit (such as state and local property taxes). However, your deductions for business-type expenses (such as rent or advertising) will be limited to the excess of your gross income from the hobby over those expenses that are deductible whether or not the business is engaged in for profit. Deductible hobby expenses are claimed on Schedule A of Form 1040 as miscellaneous itemized deductions subject to a 2%-of-AGI "floor."

There are two ways to avoid the hobby loss rules. The first way is to show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing, or racing horses). The second way is to run the venture in such a way as to show that you intend to turn it into a profit-maker, rather than operate it as a mere hobby. The IRS regs themselves say that the hobby loss rules won't apply if the facts and circumstances show that you have a profit-making objective.

How can you prove that you have a profit-making objective? In general, you can do so by running the new venture in a businesslike manner. More specifically, IRS and the courts will look to the following factors:

• how you run the activity
• your expertise in the area (and your advisers' expertise)
• the time and effort you expend in the enterprise
• whether there's an expectation that the assets used in the activity will rise in value
• your success in carrying on other similar or dissimilar activities
• your history of income or loss in the activity
• the amount of occasional profits (if any) that are earned
• your financial status
• whether the activity involves elements of personal pleasure or recreation

The classic "hobby loss" situation involves a successful businessperson or professional who starts something like a dog-breeding business, or a farm. But IRS's long arm also can reach out to more commonplace situations, such as businesspeople who start what appears to be a bona-fide sideline business.

Please contact our office to get more details on whether a venture of yours may be affected by the hobby loss rules, and what you should do right now to avoid a tax challenge.

ALERT – Deadline Change for Information Returns

A new federal law has moved up the filing date for W-2s and certain 1099 forms.  Under the new law, employers (and paid preparers) must submit copies of these forms to the IRS and SSA by January 31.  This change is effective with the 2016 information forms that will be due on January 31, 2017.  The accelerated deadline is intended to help the IRS spot errors on returns and make it easier for the IRS to verify the legitimacy of tax returns filed.

Previously, a copy of these forms was required to be provided to recipients by January 31, but employers (and paid preparers) had until the end of February (if filing on paper) or March (if filing electronically) to send copies to the Internal Revenue Service (IRS) and the Social Security Administration (SSA).

A 30-day extension is available for IRS submission.  If an extension is necessary, Form 8809 Application for Extension of Time to File Information Returns must be completed as soon as possible, but no later than January 31.

 

Handouts for Township Officials

On Wednesday, November 30, 2016, Curtis Root, CPA, gave a presentation on issues related to the upcoming audit cycle for local township officials.  The handouts mentioned in the presentation can be viewed and downloaded here.  Larsson, Woodyard & Henson would be pleased to answer any follow up questions.  Please contact us with any questions you have.

ALERT! Proposed Overtime Rule Blocked

ALERT!  The proposed overtime rules will not take effect on December 1, 2016.  A federal court has issued a preliminary injunction blocking implementation at this time.  View more about this at http://www.reuters.com/article/us-usa-employment-overtime-idUSKBN13H2JY.

New Overtime Rules

The Department of Labor’s “final rule” updating overtime regulations has recently been released.  The effective date of the new regulations is December 1, 2016. 

 

The final rule includes the following changes to overtime:     

• The salary threshold has increased to $913 per week ($47,476 annually) in order for overtime pay to not be required. 

• The salary threshold for highly compensated employees has increased to $134,004, which is the current equivalent of the 90^th percentile of full time salaried workers nationally.

• Salary thresholds will now be updated every three years beginning on January 1, 2020.  The Department of Labor will publish the updated rates on the Wage and Hour Division’s website 150 days prior to their effective date.

• Nondiscretionary bonuses and incentive payments, including commission, may be used toward the salary threshold.  These amounts must be paid at least quarterly to be considered and cannot exceed 10 percent ($4,748) of the new salary basis level.  Discretionary bonuses (such as Christmas or year-end bonuses) cannot be used toward the salary basis level.

The final rule did not change the duties tests for the administrative, executive, professional, or highly compensated employee exemptions.  An exempt employee must also still be paid a salary to be considered for overtime exemption.

 

Remember that overtime is not based on the number of hours worked on any given day during the week but rather on the number of hours worked in a seven-day work week.  There are some exceptions to this (such as prevailing wage work).  Hours worked does not include time where the employee was not performing work such as holiday and vacation time.

 

There are several actions that can be taken to comply with the new overtime rules.  We can assist you with determining what actions, if any, you should consider for your employees.

• Increase your employees’ salaries to comply with the new levels if they meet the duties test.

• Consider hiring additional employees to cover the workload and limited non-exempt employees to 40 hour work weeks to reduce overtime premiums.

• Reduce any salaries that previously included overtime and pay the appropriate overtime premiums instead.

• Consider limiting employee travel time to business hours.

If you have a new employee start during the year, they must earn at least $913 per week to be considered for the exemption.  Overtime is based on a seven-day work week – not an annual amount.  The minimum weekly amount may be translated into equivalent amounts for periods longer than one week up to one month.

 

You are not required to exempt your employees from overtime if they meet both the salary and duties tests.  You may still pay them overtime if you wish.  These rules simply state the requirements and exceptions to overtime regulations.

 

Please contact us if you need any assistance interpreting or complying with these new rules.

Converting a home into rental property

You have decided to move to another residence, but find it difficult to sell your present home. One way to weather a soft residential selling market is to rent out your present home until the market improves. If you are thinking of taking this step, you no doubt are fully aware of the economic risks and rewards. However, you also should be aware that renting out your personal residence carries potential tax benefits and pitfalls.

You generally are treated like a regular real estate landlord once you begin renting your home to others. That means you must report rental income on your return, but also are entitled to offsetting landlord-type deductions for the money you spend on utilities, operating expenses, and incidental repairs and maintenance (e.g., fixing a leak in the roof). Additionally, you can claim depreciation deductions for your home. You can fully offset your rental income with otherwise allowable landlord-type deductions. However, under the tax law passive activity loss (PAL) rules, you may not be able to currently deduct the rent-related deductions that exceed your rental income unless an exception applies. Under the most widely applicable exception, the PAL rules won't affect your converted property for a tax year in which your adjusted gross income doesn't exceed $100,000, you actively participate in running the home-rental business, and your losses from all rental real estate activities in which you actively participate don't exceed $25,000.

You should also be aware that potential tax pitfalls may arise from the rental of your residence. Unless your rentals are strictly temporary and are made necessary by adverse market conditions, you could forfeit an important tax break for home sellers if you finally sell the home at a profit. In general, you can escape taxation on up to $250,000 ($500,000 for certain married couples filing joint returns) of gain on the sale of your home. However, this tax-free treatment is conditioned on your having used the residence as your principal residence for at least two of the five years preceding the sale. So renting your home out for an extended time could jeopardize a big tax break. Even if you don't rent out your home so long as to jeopardize your principal residence exclusion, the tax break you would have gotten on the sale (i.e., exclusion of gain up to the $250,000/$500,000 limits) will not apply to the extent of any depreciation allowable with respect to the rental or business use of the home for periods after May 6, 1997, or to any gain allocable to a period of nonqualified use (i.e., any period during which the property is not used as the principal residence of the taxpayer or the taxpayer's spouse or a former spouse, such as a rental) after Dec. 31, 2008. A maximum tax rate of 25% applies to this gain (attributable to depreciation deductions).

Some homeowners who bought at the height of a market may ultimately sell at a loss. In such situations, the loss is available for tax purposes only if the owner can establish that the home was in fact converted permanently into income-producing property, and isn't merely renting it temporarily until he can sell. Here, a longer lease period helps an owner. However, if you are in this situation, you should be aware that you probably won't wind up with much of a loss for tax purposes. That's because basis (cost for tax purposes) is equal to the lesser of actual cost or the property's fair market value when it's converted to rental property. So if a home was bought for $300,000, converted to rental property when it's worth $250,000, and ultimately sold for $225,000, the loss would be only $25,000.

The question of whether to turn a principal residence into rental property isn't easy to resolve. We can review your situation in detail and guide you to an answer that makes the most sense for you.  Contact us at http://www.lwhcpa.com/contactus.

Retention of Tax Records

How long you should retain your personal income tax records? You may have to produce those records if IRS (or a state or local taxing authority) audits your return or seeks to assess or collect a tax. In addition, lenders, co-op boards, or other private parties may require that you produce copies of your tax returns as a condition to lending money, approving a purchase, or otherwise doing business with you.

Keep returns indefinitely and the supporting records usually for six years. In general, except in cases of fraud or substantial understatements of income, IRS can only assess tax for a year within three years after the return for that year was filed (or, if later, three years after the return was due). For example, if you filed your 2015 individual income tax return by its original due date of April 18, 2016, IRS will have until April 18, 2019, to assess a tax deficiency against you. If you file your return late, IRS generally will have three years from the date you filed the return to assess a deficiency.

However, the three-year rule isn't ironclad. The assessment period is extended to six years if more than 25% of gross income is omitted from a return. In addition, where no return was filed for a tax year, IRS can assess tax at any time (even beyond three or six years). If IRS claims that you never filed a return for a particular year, keeping a copy of the return will help you to prove that you did.

While it's impossible to be completely sure that IRS won't at some point seek to assess tax, retaining tax returns indefinitely and important records for six years after the return is filed should, as a practical matter, be adequate. If you file a return electronically, the company that prepared and/or filed your return is required to provide you with a paper copy of the return. Be sure to get and retain that copy.

Property Records

Records relating to property may have to be kept longer. The tax consequences of a transaction that occurs this year, such as a sale of property, may depend on events that happened years ago. The period for which you should retain records must be measured from the year in which the tax consequences actually occur.

Separation or Divorce

If separation or divorce becomes a possibility, be sure you have access to any tax records affecting you that are kept by your spouse. Or better still, make copies of the tax records, since relations may become strained and access to the records may be difficult. Copies of all joint returns filed and supporting records are important, since both spouses are liable for tax on a joint return, and a deficiency may be asserted against either spouse.

Your records should include a copy of the divorce decree or agreement of separate maintenance, which may be needed to substantiate alimony payments and distinguish them from child support or a property settlement. Your records should also include agreements or decrees over custody of children and any agreements about who is entitled to claim an exemption for them.

Retain records of the cost of all jointly-owned property. Also, get records as to the cost or other basis of all property your spouse or former spouse transferred to you during your marriage or as a result of the divorce, because your basis in that property is the same as your spouse's or former spouse's basis in it was.

Electronic Records Storage

You may keep your records in electronic form instead of or in addition to keeping paper copies. The periods for which the records should be kept are the same as for paper records. If your tax records are stored on your computer's hard drive, you should back it up to an external storage device or on paper.

To safeguard your records against loss from theft, fire or other disaster, you should consider keeping your most important records in a safe deposit box or other safe place outside your home. In addition, consider keeping copies of the most important records in a single, easily accessible location so that you can grab them if you have to leave your home in an emergency.

Loss of Records

If, in spite of your precautions, records are lost or destroyed, it may be possible to reconstruct some of them. For example, a paid tax return preparer is required by law to retain, for a period of three years, copies of tax returns or a list of taxpayers for whom returns were prepared. Most preparers comply with this rule by retaining copies (sometimes for a longer period than the legally required three years) and can furnish a copy if yours is not available.

 Similarly, other professionals who assisted you in a transaction may retain records relating to the transaction. For example, a stockbroker through whom you bought securities may be able to help you to determine the basis of the securities, and an attorney who represented you in the purchase of your home may retain records relating to the closing.

Nonetheless, because you can never be sure whether third parties will actually have the records you need, the safest course of action is to keep them yourself, in as safe a place as possible.

If you have any questions or wish to discuss this matter further, please let us know.

2015 Tax Law Changes You Won't Want to Miss!

Tax laws constantly changing can be confusing for most taxpayers. Often times, tax laws are changed with few people outside the tax profession ever noticing. Some provisions to tax laws are still being phased in from prior years and there are uncertainties about which tax breaks will be extended for future years.

In 2015, congress passed the “Protecting Americans from Tax Hikes Act of 2015” (PATH), which brought relief of uncertainties for many tax laws. We have outlined some important changes, permanent provisions, and extended provisions, that were included in the PATH bill.

Changes in 2015

Health Insurance Penalty

If you did not have full health coverage in 2014 and did not qualify for an exception, chances are you only paid $95 per person or 1% of your household income as a penalty.

For 2015, this penalty is significantly increased. If you are not fully covered by health insurance and do not quality for an exception, you will be paying $325 per person or 2% or your household income, whichever is greater.

Caution: Some exceptions require you to apply for a certificate from the state or federal marketplace. This needs to be done promptly in order to have the required exemption certificate number for the tax return.

IRA Rollovers

Before 2015, taxpayers could easily “borrow” retirement money by withdrawing funds from one IRA and waiting 60 days before they rolled it over into another IRA. Taxpayers did not have a limit on the amount of rollovers.

As of 2015, taxpayers are limited to one rollover in a 12-month period. However, if you are moving IRA funds using “trustee-to-trustee” transfers, there is no limit.

Some Individual Provisions Made Permanent

Enhanced Child Tax Credit: In addition to a $1,000 credit per qualifying child, parents are entitled to an additional refundable credit equal to 15% of earned income in excess of $3,000. In 2017, the threshold would have been raised back to $10,000; however, the $3,000 threshold was made permanent.

Enhanced American Opportunity Tax Credit: Taxpayers are entitled to a $2,500 credit for four years of post-secondary education, with phase-outs beginning at $80,000 (if single) and $160,000 (if married filing jointly). The credit would have been reduced to $1,800 with lower phase-out thresholds in 2017; however, the $2,500 credit was made permanent.

Enhanced Earned Income Credit: The enhancements to the Earned Income Credit were set to expire in 2017. The passing of the PATH bill made the enhanced credit for families with three or more children permanent and increased the phase-out for married couples filing jointly to $53,267.

Educator Expense Deduction: The $250 educator expense deduction for K-12 supplies is now a permanent deduction. Furthermore, the deduction will be indexed for inflation, meaning educators will be receiving a higher deduction in future years.

Charitable Donations: The deduction for charitable contribution of real property for conservation purposes is now permanently allowed. Taxpayers over 70 ½ may make donations directly from an IRA and will not be taxed on the amounts (up to $100,000). A shareholder in an S Corporation will be required to reduce his/her basis in the S Corporation’s stock under Section 1366 only for his/her share of the basis of property contributed by the S Corporation; not the fair market value.

Individual Provisions Extended

Bonus Depreciation: The 50% bonus depreciation was extended for property placed in service during 2015 through 2019; the 50% rate is phased down to 40% for property placed in serviced during 2018 and 30% for property placed in serviced during 2019

Energy Incentives: A $500 credit for the purchase of certain non-business energy-efficient property has been extended for two years. Also, Section 179 expensing of certain heating, cooling, and lighting improvements to commercial property has been extended for two years.

Business Provisions Made Permanent

Enhanced Section 179 Deduction: The Section 179 Deduction limit is now permanent at the $500,000 level. However, businesses exceeding a total of $2 million of purchases in qualifying equipment have a phase-out dollar-for-dollar and completely eliminated about $2.5 million. Additionally, the Section 179 Deduction will be indexed to inflation in $10,000 increments in future years.

Abbreviated 15-Year Life: Qualified retail, restaurant, and retail improvements can be depreciated over the shortened 15, rather than 39, year recovery life. This abbreviated asset life has been made permanent.