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The Brock's business, Westchester Wood, has the following income and expenses. Income: Receipts from sales of unfinished furniture Receipts from services to stain/paint furniture Receipts from sales of paint and stain products Expenditures: Cost of furniture Cost of stains and paints Depreciation expense on building Advertising Auto expenses (delivering furniture) Loading dock (new) Utilities Insurance Labor (to stain/paint furniture) Property taxes Delivery truck (used truck) Bank fees Telephone Computer Meals and entertainment Accounting Landscaping Maintenance $65,000 12,000 1,000 $38,000 2,500 7,000 1,200 900 22,000 6,000 3,500 9,800 5,000 9,500 2,000 2,500 1,300 1,800 6,000 2,400 1,200 The amount for landscaping includes $800 for maintaining the Brock's personal residence. The utilities include $2,000 of oil that was delivered to the Brock's home. 1. 2. Assume Westchester Wood is a business: a. identify which expenditures are ordinary, necessary and reasonable, b. whether the expenditures should capitalized or expensed, and c. calculate net income or loss. Assume that Westchester Wood is a hobby: a. identify expenditures (ignore any that would be capitalized) that are allowed and to what extent and b. identify which expenditures are Tier 1, Tier 2 or Tier 3 expenses. Generally, taxpayers maintain proper supporting documentation for their income and expenses. However, occasionally, taxpayers will come to your office with the expectation that you will prepare their tax return based on little or no information to support their expenses. This will present more of a problem for the taxpayer than the tax preparer. However, as the tax preparer, you should be conscious of what you are being asked to put on the tax return. Typical documentation that individuals receive will come from financial institutions such as banks, mortgage companies, and investment companies; local governments such as the tax collector; and employers. If this documentation is misplaced, in most cases, it is fairly easily replaced. Problems can arise when the taxpayer has a business and files Schedule C. When documentation is not properly maintained for a business enterprise, reporting accurate income and expenditures can be difficult. In these situations it is best to explain to the client the substantiation requirements but it may be more helpful to the client to suggest an accounting package that will assist with maintaining proper information. Of course, we can't make clients maintain the proper documentation but we can attempt to make it easier for them. The process for maintaining documentation is straight-forward. However, owners of small businesses generally spend their time running a business rather than keeping up with record-keeping. When we see this happening, we can become trusted advisors by offering valuable and potentially money-saving advice. A little time upfront with your client will be better than a great deal of time working through an IRS audit. Discussion question from this week and repsonses: If a taxpayer can deduct expenses to the extent of gross income for a hobby, is there really no taxable income? And what would be the benefit, to the taxpayer, of having it considered a for profit activity by the IRS? Upon inquiry by the IRS, a taxpayer was unable to show that his activity had a profit in three of the past five years. Therefore, the IRS deemed the activity to be a hobby. The taxpayer believes the activity to be profit motivated. How would the taxpayer prove that the activity is profit motivated? Discuss ideas that might convince the IRS that the activity is profit motivated. What other options does the taxpayer have? Responses: The benefit for a tax payer to have a for profit activity is that there is not the cap like there is for a "hobby loss rule". If you are going to write off expenses from a not for profit hobby related activity, you are limited to the amount that can be written off. The tax payers could try doing a few different things in order to prove that their hobby is actually profit motivated. The first thing I would suggest is making a case for the expenses incurred. For example, if I really like to kayak and engage in water sports but my "business" is to teach lessons to people but it is difficult to distringuish if I am actually teaching or taking friends out or just traveling the world and white water rafting and kayaking and trying to write off those expenses. I could try to provide supportingresearch regarding the necessity for safety equpiment and equpiment in general due to wear and tear and the rate at which my water boats fall apart from use, or provide supporting details of why I need to travel to certain areas of the country or world to teach the kayak and rafting lessons perhaps because there are only certain kinds of bodies of water that are best for that type of thing. I guess this is kind of a stretch, but it's the first thing that came to mind. I think that if you could prove that each place I traveled to I had a customer, then it may help to build a bigger case. 2. According to the IRS Publication 535 which covers business expenses, if you don't meet the requirement of showing a profit for 3 out of the past 5 years, you can still try to proved your activity is a business. They show a list of nine different ways to do so: Carry on activity in a business like manner. Put time and effort into the activity. The activity must be depended on for your income. The losses have been because of circumstances beyond your control. Have knowledge to successfully carry on the activity. You have been successful with the activity in the past. A profit has been shown in the past. There is an expectation to make future profits from the appreciation of asset. If the taxpayer is unable to show the activity is profit motivated, forming an entire separate business entity may also be an option in order to show the taxpayer is motivated. http://taxes.about.com/od/taxplanning/a/loss_strategies.htm