Tax Question, Losing Business of Jazz

[d]

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Illegal.

why would it be illegal to not claim expenses?
would it also be illegal for him to claim income which was in fact never received?

[retire@40]

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Originally Posted by d why would it be illegal to not claim expenses?

Because you'd be in violation of Rev Rul 56-407

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would it also be illegal for him to claim income which was in fact never received?

Someone would either have to be 1) very stupid or 2) very conniving to want to report income that was never received.

Under the "stupid" category, I would say it would not be illegal.

Under the "conniving" category, I would say it would be illegal.

[Craig]

In my nefarious past, I was a Tax Manager at KPMG. But, that was so long ago, my tax knowledge is probably less than most of the folks on this board.


The debate is hitting all the hot points. In the final analysis Al, an auditor would probably tell you that you can take deductions up to the amount of your 1099 income ... anything else would be disallowed as a hobby loss.

The practical answer is that your numbers are small enough (no offense ) that this is unlikely to get much scrutiny. From what you're telling us, I assume your net annual loss is $450 to $600.

'Course, the real solution is a top 40 song, go platinum, make $1M, and blow this popsicle stand ... at which point you have a different tax problem.

[runchman]

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Originally Posted by retire@40 Then where does it come from? At some point, the expense does come out of your pocket.

The theory is that this expense is money you are setting aside to eventually replace your equipment.

In reality you don't set the money aside, then sell your laundromat for pennies on the dollar years down the road when your equipment is all old crap So that is when it comes out of your pocket, I suppose.

- John

[retire@40]

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Originally Posted by runchman The theory is that this expense is money you are setting aside to eventually replace your equipment. In reality you don't set the money aside, then sell your laundromat for pennies on the dollar years down the road when your equipment is all old crap So that is when it comes out of your pocket, I suppose.

I never heard of that theory.

The only theory I heard of is the theory of the allocation process whereby a cost (that already happened, not one that will or may happen) is allocated to future periods in order to match costs with revenues.

So, depreciation is an apportionment of a past expense that was not fully recognized as an expense in the past.

[Buddha44]

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Originally Posted by retire@40 Because you'd be in violation of Rev Rul 56-407

Rev Rul 56-407 applies for purposes of computing self employment income and self employment tax (people wanted to pay some self employment tax so they could get credit for social security purposes).

I would not say that it is "illegal" not to claim deductions to which you are entitled to. I am not aware of anything that compels a taxpayer to do so for purposes of computing taxable income. Of course, you cannot claim it in a different year so you essentially forego it, and if it is depreciation, there are rules that state that depreciation which is "allowed or allowable" are treated as deducted.

I recall a court case on Section 183 hobby losses which the IRS lost where a profit of $1 counted as a profitable year for purposes of the 3 out of 5 year test. However, the fact that $1 of profit was generated was not in dispute.

Having said that, to deliberately not take a deduction so that you generate a minimal profit in order to qualify for the 3 out of 5 year test and take a significant loss in another year is a separate issue. Here, the intent of not taking a deduction is for purposes of taking additional deductions in another year. I would suspect that the IRS would certainly have a problem with that.

My Circular 230 disclaimer follows:

The following is not tax advice and any U.S. federal tax advice included in this communication was not intended to be used, and cannot be used, for the purpose of avoiding U.S. federal tax penalties.

[retire@40]

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Originally Posted by Buddha44 Rev Rul 56-407 applies for purposes of computing self employment income and self employment tax (people wanted to pay some self employment tax so they could get credit for social security purposes). I would not say that it is "illegal" not to claim deductions to which you are entitled to. I am not aware of anything that compels a taxpayer to do so for purposes of computing taxable income...

You don't think the bolded portion of that revenue ruling compels a taxpayer to claim all allowable deductions? The word "must" is used, not "may."

The question has been presented whether taxpayers may disregard depreciation and other allowable deductions in computing net earnings from self-employment for self-employment tax purposes. Held , under section 1402(a) of the Self-Employment Contributions Act of 1954 (chapter 2, subtitle A, Internal Revenue Code of 1954), as amended, every taxpayer, with the exception of certain farm operators, must claim all of his allowable deductions, including depreciation, in computing his net earnings from self-employment for self-employment tax purposes.

[runchman]

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Originally Posted by retire@40 I never heard of that theory. The only theory I heard of is the theory of the allocation process whereby a cost (that already happened, not one that will or may happen) is allocated to future periods in order to match costs with revenues. So, depreciation is an apportionment of a past expense that was not fully recognized as an expense in the past.

Well, I don't know, maybe it's just semantics, but in my situation it has worked like this (rounding off numbers because I'm going from memory)

bought my mat for 80k, something like 75k of that price deemed for the equipment, which is depreciable.

That equipment is depreciated over some time frame (5 or 7 years, I forget). The irs has different methods to calculate how this 75k is divied up into these years.

In my case the first year of operation I had something like 20k in depreciation. My gross minus expenses for the year were 18k, so I made an 18k profit. but the 20k depreciation expense comes off of this, so for tax purposes I lost 2K. So I had a 20k 'expense' that wasn't really an expense.

Now the flipside is if I turn around and sell the mat tomorrow for the same 80k I bought it for, the gain on my sale is (origPrice - (origPrice-depreciation)) or 80 - (80-20) = 20k. This is what I'm taxed on at sale time.

So in the end I give the government back those tax dollars that the depreciation deduction saved me. There is no free lunch.

Sorry, I didn't mean to turn this discussion into my laundromat tax analysis !

- John

[retire@40]

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Originally Posted by runchman bought my mat for 80k, something like 75k of that price deemed for the equipment, which is depreciable...In my case the first year of operation I had something like 20k in depreciation. My gross minus expenses for the year were 18k, so I made an 18k profit. but the 20k depreciation expense comes off of this, so for tax purposes I lost 2K. So I had a 20k 'expense' that wasn't really an expense...

You had an "expenditure" of $75K for equipment that is "expensed" over the estimated useful life of the equipment. So it really is an expense since you are trying to match the use of that equipment with the revenue it is helping you produce. There wear and tear on the equipment is what you are accounting for over time.

[Meadbh]

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Originally Posted by TromboneAl But he would always tell me that if if was run like a business, and had a reasonable chance of making a profit, that I was OK. I seem to remember someone telling me that if the 3/5 law were true, Ford (or GM?) would be designated as a hobby. Ha ha.

How true! At what point will Ford have to fess up?

[justin]

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Originally Posted by Meadbh How true! At what point will Ford have to fess up?

Ford's a C corp. They don't ever encounter the issue of hobby losses, since they don't file individual income tax returns. Ford doesn't try to offset income from other sources by claiming their loss (although they do get a carryforward loss).

[justin]

re: issue of not counting deductions to artificially increase your income or including income that isn't real:

There are a few refundable tax credits that become available as your income increases. The earned income credit and the additional child tax credit come to mind. For these two credits, you might benefit by artificially increasing your income by either ignoring deductions or by falsifying actual income. IRS might not like that too much. No idea if there is a ruling/reg or tax court case on that.

[Buddha44]

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Originally Posted by retire@40 You don't think the bolded portion of that revenue ruling compels a taxpayer to claim all allowable deductions? The word "must" is used, not "may." The question has been presented whether taxpayers may disregard depreciation and other allowable deductions in computing net earnings from self-employment for self-employment tax purposes. Held , under section 1402(a) of the Self-Employment Contributions Act of 1954 (chapter 2, subtitle A, Internal Revenue Code of 1954), as amended, every taxpayer, with the exception of certain farm operators, must claim all of his allowable deductions, including depreciation, in computing his net earnings from self-employment for self-employment tax purposes.

You are missing my point. I said that I agree as it applies to self employment income. Self employment income is not taxable income. For purposes of computing taxable income, I am not aware of any ruling that mandates all deductions be taken. In general, it would not benefit a taxpayer not to take a deduction he is otherwise entitled to. Section 161 states that a taxpayer is "allowed as deductions". Nowhere does it say a taxpayer must take them. Where this becomes an issue is if not taking a deduction results in a tax benefit which is greater than the deduction foregone, which is a separate issue, a point I also referred to.

Please refer to my Circular 230 disclosure above.

[retire@40]

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Originally Posted by Buddha44 ...I said that I agree as it applies to self employment income...

Ok, we're in agreement then.

This thread was only about self-employment income/expenses and all I was talking about was expenses related to self-employment income in responding to a question about Schedule C.

[TromboneAl]

Thanks for the help. You've given me a good understanding of the issue, and I'll continue to track expenses, and at the end of they year evaluate whether the small gain I'll get by claiming the expenses will be worth entering a relatively gray area of the tax code.

Two New Questions:

1. Let's say that the IRS did decide that I was wrong. Would they just recalculate my tax, or would they call me in for an audit?

2. Let's say that in 2007 I receive no 1099's. All my income comes from cash or from personal checks (e.g. for wedding). And let's say I'm confident that my expenses will exceed my income.

Can I just ignore all my income/expenses when it comes to filing my income tax?

Thanks!

[Buddha44]

Al

The likelihood that your business or hobby operates at a loss does not relieve you from reporting the gross income earned on your tax return. This is true regardless of whether or not you receive a 1099 or are paid in cash. And, as other people have mentioned, not having a detailed ledger or accounting system which records all income and expenses is a significant consideration as to whether or not you are operating a business or engaging in a hobby.

My recommendation is always to report all gross income earned and take the allowed deductions.

As to your specific questions,

1) This can occur either way. Typically, if it is for interest or dividends, then they may just recalculate your tax. If it is for independent contractor work, then it can be either way, although if they recalculate the tax then you have to show (and prove) your deductions if you want to claim them. This may result in an audit. The concept of risk or likelihood of an audit should not be used to decide how to report your income.

2) If an audit occurs, the IRS would likely scrutinize your expenses in much greater detail. As I noted earlier, the IRS will try to track your gross income. Claiming the deductions (and proving them) are your responsibility. Further, underreporting of gross (not net) income -- which is what you would be doing, even if the deduction you otherwise would have claimed exceeded your gross income -- by 25% or more extends the statute of limitations from 3 years to 6 years. Claiming that you would have a net loss is not a viable defense. My recommendation is to report the income and claim the deductions. If it is a hobby (or treated as such), your net loss cannot offset other income.

Almost every year, around this time, a high profile arrest is made (think Leona Helmsley, Darryl Strawberry). Strawberry did not report income from baseball autographs. I am sure he had expenses (perhaps reimbursed) such as hotel, flying, etc., that he may have legitimately claimed, but he was arrested for not reporting the income. It was unbelievable that he got no jail time.

Good luck and please see Circular 230 disclosure above.

[TromboneAl]

I think I've finally found a good solution to this problem. Remember the basic problem is that when driving expenses are included, I usually have a loss for my jazz business, and the IRS may consider it a hobby. It would be illegal to not report all my expenses.

However, on most trips into town for a gig I might do something else (buy some food, get gas, etc.), so I just won't report the trip expense for those. I'm guessing that I'll be ending up with a very small profit most years.

I'd hoped to avoid filling out a Schedule C, but I'd rather do things by the book.