1. © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Essentials of Taxation 1 Chapter 11 Individuals as Employees and Proprietors

2. The Big Picture (slide 1 of 3) Mark and Mary Herman come to you for tax advice. Mark Herman is a self-employed consultant. –Last year, Mark’s business generated revenue of $165,000 and incurred expenses of $18,000 for rent and utilities. –Mark also spent $8,000 purchasing depreciable equipment. –He paid a part-time secretary $12,000 for administrative work. –He hired an assistant and paid her $40,000. –Mark paid $3,000 for his own health insurance and $500 for term life insurance –He did not contribute to any retirement plans.

3. The Big Picture (slide 2 of 3) Mary (Mark’s wife) also works as a consultant but for a large firm. –Her salary last year was $85,000. –Mary’s employer paid $3,000 of premiums for her health insurance and provided $50,000 of group term life insurance. – Mary is not covered by a qualified retirement plan. She contributed $5,500 to a traditional IRA. –Mary routinely travels for her job. She was reimbursed by her employer for all travel expenses. –In addition, Mary spent $500 on other unreimbursed employee business expenses.

4. The Big Picture (slide 3 of 3) What are the tax consequences of these items? –Can Mark and Mary deduct the expenses they incurred? –Are there other tax planning opportunities that the couple may be missing or tax issues of which they should be aware? Read the chapter and formulate your response.

5. 5 Employee vs. Self-Employed (slide 1 of 2) Business expenses for self-employed persons are deductible for AGI –Reported on Schedule C Unreimbursed business expenses for employees are generally deductible from AGI subject to 2% of AGI floor –Reported on Form 2106 (Employee Business Expenses) and Schedule A (Itemized Deductions)

6. 6 Employee vs. Self-Employed (slide 2 of 2) Person is classified as an employee if: –Subject to will and control of another with respect to what shall be done and how it shall be done –Another furnishes tools or the place of work –Income based on time spent rather than task performed –Other factors

7. The Big Picture – Example 1 Self-employed Individual Return to the facts of The Big Picture on p. 11-1. Mark is a consultant whose major client accounts for 60% of his billings. –He does the routine consulting work at the client’s request. –He is paid a monthly retainer in addition to amounts charged for extra work. Mark is a self-employed individual. –Even though most of his income comes from one client, he still has the right to determine how the end result of his work is attained.

8. The Big Picture – Example 2 Employee Vs. Self-employed Return to the facts of The Big Picture on p. 11-1. Ellen is a recent MBA graduate hired by Mark to assist him in the performance of services for the client mentioned in Example 1. Ellen is under Mark’s supervision; he reviews her work and pays her an hourly fee. Ellen is Mark’s employee.

9. 9 Advantages of Qualified Fringe Benefits Cost of qualified fringe benefits is deductible by employer Value of qualified fringe benefits is excluded from employee’s gross income

10. 10 Employer-Sponsored Accident and Health Plans (slide 1 of 2) Premiums paid by employer for insurance coverage of employee, spouse, and dependents are not taxable to employee Amounts received from insurance are not taxable when received for medical care or for permanent loss of body part or function

11. 11 Employer-Sponsored Accident and Health Plans (slide 2 of 2) Payments for expenses that do not meet the Code’s definition of medical care must be included in gross income Amounts received for medical expenses deducted on a prior return must be included in gross income

12. 12 Long-Term Care Insurance (slide 1 of 2) Employer paid insurance premiums for employee’s long- term care are excludible subject to annual limits as follows:

13. 13 Long-Term Care Insurance (slide 2 of 2) Exclusion of benefits received from policy is limited to the greater of: $330 in 2014 for each day patient receives long-term care (indexed amount for 2013 is $320) The actual cost of the care –Reduced by any amounts received from other third parties (e.g., damages received)

14. 14 Meals and Lodging Not taxable to employee if: –Furnished by employer On employer’s business premises For convenience of employer –In the case of lodging, employee is required to accept lodging as a condition of employment

15. 15 Meals and Lodging Not taxable to employee if: –Furnished by employer On employer’s business premises For convenience of employer –In the case of lodging, employee is required to accept lodging as a condition of employment

16. 16 Meals and Lodging Not taxable to employee if: –Furnished by employer On employer’s business premises For convenience of employer –In the case of lodging, employee is required to accept lodging as a condition of employment

17. 17 Meals and Lodging Not taxable to employee if: –Furnished by employer On employer’s business premises For convenience of employer –In the case of lodging, employee is required to accept lodging as a condition of employment

18. 18 Group Term Life Insurance Premiums on the first $50,000 of group term life insurance are excluded from gross income –For each $1,000 of coverage in excess of $50,000, the employee must include the amounts calculated using the IRS tables If plan discriminates in favor of certain key employees (e.g., officers), they are not eligible for the exclusion –In such a case, key employees must include in gross income the greater of Actual premiums paid by the employer, or The amount calculated from the IRS tables

19. 19 Group Term Life Insurance

20. 20 Other Fringe Benefits (slide 1 of 3) Dependent care –Up to $5,000 of care costs paid for by employer can be excluded Athletic facilities –Value of use of athletic facilities located on employer premises can be excluded

21. 21 Other Fringe Benefits (slide 2 of 3) Educational assistance programs –Employer-provided educational assistance for undergraduate and graduate education is excludible Exclusion limited to $5,250 per year Includes tuition, fees, books, and supplies

22. 22 Other Fringe Benefits (slide 3 of 3) Adoption assistance programs –Employee adoption expenses paid or reimbursed by employer are excludible Exclusion limited to $13,400 Exclusion phases-out as AGI increases from $201,010 to $241,010

23. 23 Cafeteria Plans Allow employees to choose between cash and certain nontaxable benefits –If cash is chosen, the amount received is taxable –If a nontaxable benefit is chosen, the benefit remains nontaxable Provide tremendous flexibility in tailoring the employee pay package to fit individual needs

24. 24 Flexible Spending Plans Allow employees to accept lower cash compensation in return for employer agreeing to pay certain costs without the employee recognizing income –Called a use or lose plan since reduction in pay cannot be recovered if covered expenses are less than expected

25. 25 Classes of Nontaxable Employee Benefits No-additional-cost services Qualified employee discounts Working condition fringes De minimis fringes Qualified transportation fringes Qualified moving expense reimbursements Qualified retirement planning services

26. 26 No Additional Cost Services Are nontaxable if: –Employee receives services (not property) –Employer incurs no substantial additional cost in providing the services –Services offered are within line of business in which employee works –Benefit is offered on nondiscriminatory basis

27. 27 Qualified Employee Discounts Are nontaxable if: –Discount is not on realty or investment property –Item discounted is from same line of business in which employee works –Discount cannot exceed gross profit on property or 20% of the customer price on services –Benefit is offered on nondiscriminatory basis

28. 28 Working Condition Fringes Not taxable if employee could have deducted cost of item if they had actually paid for them –Includes personal use of auto by full-time auto salespeople and employee business expenses that would be eliminated by the 2% floor on miscellaneous deductions

29. 29 De Minimis Fringes (slide 1 of 2) These benefits are so small that accounting for them is impractical –Examples include: Supper money Occasional personal use of company copying machine Company cocktail parties Picnics for employees

30. 30 De Minimis Fringes (slide 2 of 2) Subsidized eating facilities operated by employer are excluded if: –Located on or near employer’s premises –Revenue equals or exceeds direct operating costs –Nondiscrimination requirements are met

31. 31 Qualified Transportation Fringes This fringe benefit is designed to encourage the use of mass transit for commuting to work –Includes: Transportation in commuter highway vehicle and transit passes –Limit on the exclusion for 2014 is $130 per month Qualified parking –Limit on the exclusion for 2014 is $250 per month Qualified bicycle commuting reimbursement –Can exclude up to $20 per month received from an employer as reimbursement for the cost of commuting by bicycle »i.e., Bicycle purchase, improvement, repair, and storage –May be provided directly by the employer or may be in the form of cash reimbursements

32. 32 Qualified Transportation Fringes This fringe benefit is designed to encourage the use of mass transit for commuting to work –Includes: Transportation in commuter highway vehicle and transit passes –Limit on the exclusion for 2015 is $130 per month Qualified parking –Limit on the exclusion for 2015 is $250 per month Qualified bicycle commuting reimbursement –Can exclude up to $20 per month received from an employer as reimbursement for the cost of commuting by bicycle »i.e., Bicycle purchase, improvement, repair, and storage –May be provided directly by the employer or may be in the form of cash reimbursements

33. 33 Qualified Transportation Fringes This fringe benefit is designed to encourage the use of mass transit for commuting to work –Includes: Transportation in commuter highway vehicle and transit passes –Limit on the exclusion for 2015 is $130 per month Qualified parking –Limit on the exclusion for 2015 is $250 per month Qualified bicycle commuting reimbursement –Can exclude up to $20 per month received from an employer as reimbursement for the cost of commuting by bicycle »i.e., Bicycle purchase, improvement, repair, and storage –May be provided directly by the employer or may be in the form of cash reimbursements

34. 34 Moving Expenses Employer payment or reimbursement of employee’s qualified moving expenses is excludible –No deduction by employee is allowed for reimbursed moving expenses

35. 35 Qualified Retirement Planning Services Value of any retirement planning advice or information provided by employer who maintains a qualified retirement plan is excluded from income –Designed to motivate more employers to provide retirement planning services

36. 36 Nondiscrimination Provisions For no-additional-cost services, qualified employee discounts, and qualified retirement planning services –If the plan is discriminatory in favor of highly compensated employees, these key employees are denied exclusion treatment –Non-highly compensated employees can still exclude these benefits from income

37. 37 Foreign Earned Income (slide 1 of 2) Income from personal services in a foreign country can be excluded from income To qualify for the exclusion, must be either: –A bona fide resident of foreign country, or –Present in foreign country at least 330 days during any 12 consecutive months

38. 38 Foreign Earned Income (slide 2 of 2) Exclusion amount is limited to $100,800 for 2015 –For married persons, both of whom have foreign earned income, the exclusion is computed separately for each spouse

39. 39 Employee Expenses Fall into one of the following categories: –Transportation –Travel –Moving –Education –Entertainment –Other –Contributions to retirement accounts

40. 40 Transportation Expenses (slide 1 of 2) Transportation expense defined –Very limited, only from job site to job site and commuting to/from temporary work place –Commuting from home to work and back is nondeductible Exceptions: –Additional costs incurred to transport heavy tools –Employees with more than one job

41. 41 Transportation Expenses (slide 2 of 2) Amount deductible –Actual expenses Must keep adequate records of all expenses and depreciation is limited, or –Automatic mileage method 57.5 cents per mile for business miles for 2015 –Adjustment to basis of auto is required for depreciation considered allowed Plus parking, tolls, etc. Adequate documentation of mileage required

42. 42 Travel Expenses (slide 1 of 2) Travel expense defined –Expenses while “away from tax home” overnight on business –Includes transportation, lodging, 50% meals, and miscellaneous expenses

43. 43 Travel Expenses (slide 2 of 2) “Away from home” requirement –Need not be a 24-hour period but must be longer than ordinary work day and taxpayer will need to rest during release time –Being “away” should be a temporary situation (not in excess of 1 year) –“Tax Home” generally means business location, post, or station of the taxpayer

44. 44 Combined Business/Pleasure Travel (slide 1 of 4) Only actual expenses for business are deductible –Meals, lodging and other expenses must be allocated between business and personal days Deductibility of transportation costs depends on whether the trip is domestic or foreign

45. 45 Combined Business/Pleasure Travel (slide 2 of 4) For domestic travel –If primary purpose of trip is business, transportation is deductible in full –If primary purpose is pleasure, no deduction for transportation allowed, but other expenses (e.g., lodging) associated with business days are deductible

46. 46 Combined Business/Pleasure Travel (slide 3 of 4) For foreign travel –Transportation expenses must be allocated between business and personal unless: Trip is 7 days or less, Less than 25% of time was for personal purposes, or Taxpayer had no substantial control over arrangements for the trip

47. 47 Combined Business/Pleasure Travel (slide 4 of 4) Travel days are considered business days Weekends, legal holidays and intervening days are business days if both the preceding and succeeding days are business days If trip is primarily for pleasure, no transportation expenses are deductible

48. 48 Moving Expenses Deductible for moves in connection with the commencement of work at a new principal place of work Two tests must be met for moving expenses to be deductible –Distance test –Time test

49. 49 Moving Expenses - Distance Test Distance from old home to new job must be at least 50 miles farther than from old home to old job New home location not relevant for decision

50. 50 Example of Distance Test Gail lived 20 miles from her old job Gail’s new job is 75 miles from her old home Gail meets the distance test Old Job Old Job New Job New Job Old Residence Old Residence 20 mi. 75 mi.

51. 51 Moving Expenses - Time Test (slide 1 of 2) Taxpayer must be full-time employee for 39 weeks in the 12-month period following the move, or Self-employed must work in new location for 78 weeks during the next two years following the move –39 of the weeks must be in the first 12 months Test waived if die, disabled, discharged, or transferred

52. 52 Moving Expenses - Time Test (slide 2 of 2) If time test not met during taxable year, two alternatives: –Take the deduction in year moved. If test is not met in following year, either: Include the amount deducted in gross income in the following year, or File amended return for year of move –Alternatively, wait until time test is met and then file amended return for year of move

53. 53 Deductible Moving Expenses ‘‘Qualified’’ moving expenses include reasonable expenses of: –Moving household goods and personal effects to new location –Expenses of travel for taxpayer and family to new location Lodging Actual auto costs (not depreciation) or mileage rate of 23 cents per mile for each car in 2015 –Meals are not deductible as moving expense

54. 54 Tax Treatment of Moving Expenses Unreimbursed moving expenses are deductible for AGI Reimbursement or payment by employer: –For qualified moving expenses, amount is excluded from gross income, but no deduction for related expenses –For nonqualified moving expenses, amount is included in gross income and no deduction is allowed

55. 55 Education Expenses (slide 1 of 3) Education expenses of an employee and self- employed individual are deductible as business expenses if they are incurred: –To maintain or improve existing skills, or –To meet express requirements of the employer or requirements imposed by law to retain employment status

56. 56 Education Expenses (slide 2 of 3) Education expenses are not deductible as a business expense if they are incurred: –To meet minimum educational standards for existing job, or –To qualify taxpayer for new trade or business

57. 57 Education Expenses (slide 3 of 3) Education expenses include: –Tuition –Books –Supplies –Transportation –Travel (including lodging and 50% meals)

58. 58 Deduction For Qualified Tuition and Related Expenses (slide 1 of 3) A deduction is allowed for AGI for qualified tuition and related expenses involving higher education (i.e., postsecondary)

59. 59 Deduction For Qualified Tuition and Related Expenses (slide 2 of 3) The maximum deduction depends on filing status and AGI Filing Status AGI LimitMax Deduction Single $65,000$4,000 Married $130,000$4,000 Single $65,001 to$2,000 $80,000 * Married $130,001 to$2,000 $160,000 * *No deduction is allowed if MAGI exceeds this amount

60. 60 Deduction For Qualified Tuition and Related Expenses (slide 3 of 3) Qualified tuition and related expenses include whatever is required for enrollment –Usually, student activity fees, books, room and board are not included Expenses need not be work related Deduction is not available for married persons filing separately

61. 61 Entertainment Expenses (slide 1 of 2) Deductions are very restricted due to abuse possibilities –Deductible amount allowed: 50% of meals and entertainment costs including related taxes, tips, cover charges, parking fees, and room rental fees 100% of transportation costs –Amounts cannot be lavish or extravagant

62. 62 Entertainment Expenses (slide 2 of 2) Entertainment expenses are classified as either: –Directly related to business Actual business meeting or discussion occurs during meal or entertainment –Associated with business Meal or entertainment that directly precedes or follows business meeting or discussion

63. 63 Restrictions on Entertainment Expenses (slide 1 of 2) Club dues –Generally not deductible Exception: Clubs formed for public service and community volunteerism (e.g., Kiwanis, Rotary) –Business entertainment expenses incurred at club are still deductible (50%)

64. 64 Restrictions on Entertainment Expenses (slide 2 of 2) Business gifts –Business gifts of tangible personalty with a value of $25 or less per person per year are deductible Incidental costs (e.g., gift-wrapping) are not included in the cost of the gift in applying the limit –If the value is $4 or less (e.g., pen with company name) then not subject to $25 limit Gifts to employers or superiors are not deductible

65. 65 Office in the Home (slide 1 of 3) Deductibility is very restricted due to abuse possibilities –Office must be used exclusively and on a regular basis as: The principal place of business, or A place of business used by clients, patients, or customers –For employees, office must also be for the convenience of the employer

66. 66 Office in the Home (slide 2 of 3) What constitutes “principal place of business”? –Home office qualifies as a principal place of business if: Taxpayer conducts admin. and mgmt. activities in the home office, and There is no other fixed location where taxpayer conducts these activities

67. 67 Office in the Home (slide 3 of 3) Office in the home expenses cannot cause net loss from the business activity –Office in home deduction limited to business gross income in excess of other business expenses (ordering rules apply) –Excess is carried forward (subject to limit) –Form 8829 is used to report office in home expenses

68. 68 Other Employee Expenses A partial list of other employee expenses that are deductible includes: –Special clothing (uniforms) –Union dues –Professional expenses –Job hunting in same profession –Educator expenses (deductible for AGI) Limited to $250 per year for supplies, etc. of elementary and secondary school teachers

69. 69 Other Employee Expenses A partial list of other employee expenses that are deductible includes: –Special clothing (uniforms) –Union dues –Professional expenses –Job hunting in same profession –Educator expenses (deductible for AGI) Limited to $250 per year for supplies, etc. of elementary and secondary school teachers

70. 70 Other Employee Expenses A partial list of other employee expenses that are deductible includes: –Special clothing (uniforms) –Union dues –Professional expenses –Job hunting in same profession –Educator expenses (deductible for AGI) Limited to $250 per year for supplies, etc. of elementary and secondary school teachers

71. 71 Classification of Employee Expenses (slide 1 of 2) Depends on whether they are reimbursed and, if reimbursed, under what type of plan

72. 72 Classification of Employee Expenses (slide 2 of 2) Employers can have three types of reimbursement plans –Accountable –Nonaccountable –No reimbursement is given

73. 73 Accountable Plan (slide 1 of 2) Plan must require adequate accounting to the employer for expense reimbursed, and Any excess reimbursements must be returned to the employer

74. 74 Accountable Plan (slide 2 of 2) Adequate accounting is –Submitting a record, with receipts, to the employer, or –Using a per diem allowance that is not more than the Federal per diem rate Employee reports no income and takes no deduction to the extent of the reimbursed expenses

75. 75 Substantiation for Expenditures (slide 1 of 2) No deduction allowed for an expense if the taxpayer does not have adequate records for the expense –Therefore, taxpayers need to have good records for employee or self-employed expenses In some cases, use of per diem allowance will be deemed substantiation

76. 76 Substantiation for Expenditures (slide 2 of 2) Records should include: –The amount of the expense –The time and place of travel or entertainment (or date of gift) –The business purpose of the expense –The business relationship of the taxpayer to the person entertained (or receiving the gift)

77. 77 Nonaccountable Plan Plan that does not require adequate accounting or return of excess reimbursement or both –Reimbursed amounts received under this plan are included in gross income –Expenses are deductible from AGI as miscellaneous itemized deductions subject to the 2% of AGI limitation

78. 78 Unreimbursed Employee Expenses Expenses are deductible from AGI as miscellaneous itemized deductions subject to the 2% AGI limitation –If employee could have received, but did not seek, reimbursement for whatever reason, none of the employment-related expenses are deductible

79. 79 Individual Retirement Accounts (slide 1 of 5) Contribution ceiling is lesser of $5,500 ($11,000 for spousal IRAs) or 100% of earned income Person age 50 or over by year end may make catch-up contributions –Max contribution limit is increased by $1,000 in 2014 Deductible IRA contribution may be reduced if taxpayer is an active participant in another qualified plan To extent individual is ineligible to make deductible contributions, a nondeductible IRA contribution may be made –Income accrues on account tax deferred

80. 80 Individual Retirement Accounts (slide 2 of 5)

81. 81 Individual Retirement Accounts (slide 3 of 5 Roth IRA –Contributions are nondeductible Maximum allowable annual contribution is the smaller of –$5,500 ($11,000 for spousal IRAs) or –100% of the individual’s compensation for the year –Qualified distributions are tax-free after an initial five year holding period if: Made on or after age 59 ½ Made to beneficiary on or after participant’s death Participant becomes disabled Used to pay for qualified first-time home buyer’s expenses ($10,000 limit)

82. 82 Individual Retirement Accounts (slide 4 of 5) Roth IRA (cont’d) –Other distributions may be taxable Distributions first treated as nontaxable return of capital to extent of contributions Remaining distribution treated as taxable payout of earnings

83. 83 Individual Retirement Accounts (slide 5 of 5) Roth IRA (cont’d) –Annual contributions are subject to phase out within the AGI ranges listed below: Phase-out begins Phase-out ends Single $ 116,000 $131,000 MFJ 183,000 193,000 MFS 0 10,000

84. 84 Individuals as Proprietors A sole proprietorship is not a separate taxable entity. –Revenues and expenses from the business entity are reported on Schedule C, Form 1040. –Ordinary and necessary business expenses paid or incurred during the tax year in carrying on a trade or business are deductible on Schedule C.

85. 85 Health Insurance Premiums A self-employed taxpayer may deduct 100% of insurance premiums paid for medical coverage as a deduction for AGI –Includes premiums paid on behalf of the taxpayer, the taxpayer’s spouse, and dependents Deduction is not allowed if eligible to participate in a subsidized health plan maintained by any employer of the taxpayer or of the taxpayer’s spouse

86. 86 Payment Procedures (slide 1 of 2) Self-employment tax –Taxpayers with net self-employment earnings ≥ $400 must pay self-employment tax 2015 rates –Social Security: 12.4% of first $118,500 net self- employment income –Medicare: 2.9% of all net self-employment income These rates are twice what an employee pays

87. 87 Payment Procedures (slide 2 of 2) Self-employment tax –Taxpayer receives a deduction from net self- employment income of 7.65% for purposes of calculating the actual self-employment tax –Taxpayer receives a for AGI deduction for one- half of the self-employment tax paid

88. 88 Retirement Plans for Self-Employed Individuals (slide 1 of 2) H.R. 10 (Keogh) plans –Retirement plans for self-employed and their employees –Plan rules are similar to corporate provisions –Plan must be established before the end of the tax year, but contributions may be made up to the due date of the return

89. 89 Retirement Plans for Self-Employed Individuals (slide 2 of 2) Keogh (H.R. 10) plans (cont’d) –Contribution limitations Defined contribution plan –Lesser of $53,000 (in 2015) or 100% of earned income Profit sharing plans and stock bonus plans are limited to 25% –Defined benefit plans limit the annual benefit payable to the lesser of $210,000 (in 2015) or 100% of average compensation for 3 highest years

90. 90 SIMPLE Plans (slide 1 of 2) Employers with 100 or less employees and no other qualified plan may establish a savings incentive match plan for employees (SIMPLE plan) –In form, §401(k) or IRA –Avoids nondiscrimination rules

91. 91 SIMPLE Plans (slide 2 of 2) SIMPLE Plans –Employees make elective contributions (up to $12,500 in 2015) to plan Contributions made as percentage of compensation Distributions from plan taxed under IRA rules –Employers generally required to match contributions up to 3% of compensation or provide 2% nonmatching contributions –Person age 50 or over by year end may make catch-up contributions of up to $3,000 for 2015 and thereafter

92. 92 Estimated Tax for Individuals (slide 1 of 3) Any taxpayer (employee or self-employed) who will owe at least $1,000 in taxes for the year (and meets none of the exceptions) must make estimated tax payments

93. 93 Estimated Tax for Individuals (slide 2 of 3) To avoid penalties for underpayment, must annually pay the smaller of: –90% of the current year’s tax, or –100% of last year’s tax Exception: Increased to 110% of last year’s tax if AGI last year exceeded $150,000 ($75,000 if married filing separately)

94. 94 Estimated Tax for Individuals (slide 3 of 3) For calendar year individual taxpayer, estimated tax payments of ¼ of annual amount are due –April 15, June 15, and September 15 of the tax year, and January 15 of the following year

95. 95 Hobby Losses (slide 1 of 8) Hobby defined –Activity not entered into for profit Personal pleasure associated with activity Examples: raising horses, fishing boat charter If an activity is not engaged in for profit, the hobby loss rules apply –Hobby expenses are deductible only to the extent of hobby income

96. 96 Hobby Losses (slide 2 of 8) Profit activity –If activity is entered into for profit, taxpayer can deduct expenses for AGI even in excess of income from the activity At-risk and passive loss rules may apply Often it is difficult to determine if an activity is profit motivated or a hobby Regulations provide nine factors to consider in making this determination

97. 97 Hobby Losses (slide 3 of 8) Presumptive rule of § 183 –If activity shows profit 3 out of 5 years (2 out of 7 years for horses), the activity is presumed to be a trade or business rather than a personal hobby –Rebuttable presumption, shifts burden of proof to IRS –Otherwise, taxpayer has burden to prove profit motive

98. 98 Hobby Losses (slide 4 of 8) YearIncome (loss)Hobby? 2009$500Yes 2010(1,500)Yes 2011700Yes 2012(1,000)Yes 2013900No, profit 3 of 5 years 2014(500)Yes, profit only 2 of 5 years 20151,200No, profit 3 of 5 years

99. 99 Hobby Losses (slide 5 of 8) If an activity is deemed to be a hobby –Can only deduct expenses to extent of income from activity (i.e., cannot deduct hobby losses)

100. 100 Hobby Losses (slide 6 of 8) If an activity is a hobby: –Expenses are deductible from AGI Treated as miscellaneous itemized deductions subject to the 2% of AGI limitation Exception: expenses that are deductible without regard to profit motive are deductible in full, such as –Home mortgage interest –Property taxes

101. 101 Hobby Losses (slide 7 of 8) Order in which hobby expenses are deductible: –First: Those otherwise deductible: e.g., home mortgage interest and property taxes –Then: Expenses that do not affect adjusted basis: e.g., maintenance, utilities –Then: Expenses that affect adjusted basis: e.g., depreciation (or cost recovery)

102. 102 Hobby Losses (slide 8 of 8) Example of hobby expenses: Taxpayer sells horses raised as a hobby for $15,500 AmountOrderAmount Income$15,500 Interest6,0001$ 6,000 Taxes3,0001 Vet Bills2,0002 Feed4,0002 Depreciation1,0003 Ltd. to 500 Total15,500

103. Refocus On The Big Picture (slide 1 of 5) Mark may deduct the ordinary and necessary business expenses incurred by his proprietorship. –This includes the $18,000 for rent and utilities, the $12,000 paid to his secretary, and the $40,000 paid to his assistant. The $8,000 paid for equipment can either –Be depreciated, or –May qualify for immediate expensing under § 179. As a self-employed taxpayer, Mark may deduct 100% of the $3,000 of health insurance premiums paid –Only if he is not eligible to participate in the subsidized health plan maintained by Mary’s employer.

104. Refocus On The Big Picture (slide 2 of 5) On the other hand, Mark cannot deduct the premiums of $500 paid for his life insurance policy. Mark may want to consider contributing to his own IRA or establishing a Keogh plan or SIMPLE plan to allow for greater contributions. Mark should be aware that in addition to paying income tax on the net income earned by his business, he will also owe self- employment tax at a combined rate of 15.3% and will be able to claim an income tax deduction for part of the self- employment tax paid.

105. Refocus On The Big Picture (slide 3 of 5) Mary will owe income tax on her $85,000 salary. –The health insurance premiums of $3,000 and group term life insurance premiums paid by her employer qualify as tax-free fringe benefits. – In addition, as long as Mary is required to substantiate her travel expenses as part of an accountable plan, none of the travel-related reimbursements need to be included in Mary’s gross income. –Because Mary is not covered by a qualified retirement plan at work, she can also deduct the entire $5,500 contribution made to her IRA. –While the $500 of employee business expenses are technically deductible, they provide a tax benefit to Mary only if they exceed 2% of the couples AGI. While Mary is not subject to self-employment tax, she still incurs a 7.65% payroll tax in 2015 related to Social Security and Medicare. –Her employer pays the other 7.65%.

106. Refocus On The Big Picture (slide 4 of 5) What If? In order to improve her skills in her current job, Mary is considering entering an MBA program at a local college. At the same time, to save money while Mary is in school, Mark is considering moving his office into a vacant room in their home. Are Mary’s education expenses deductible? –If the new degree is not required to meet the minimum requirements of her existing job and does not qualify Mary for a new trade or business, Mary’s books, tuition, and other related educational expenses are deductible as a miscellaneous itemized deduction. –However, like the $500 of other employee business expenses mentioned earlier, the expenses provide a tax benefit only to the extent that they exceed 2% of the couples AGI.

107. Refocus On The Big Picture (slide 5 of 5) What If? Can Mark deduct expenses associated with his home office? –As a self-employed individual, Mark is allowed to deduct the costs of a home office as long as the office is used exclusively and on a regular basis as either the principal place of business or a place of business used by his clients and customers. –Deductible expenses would include a portion of mortgage interest and property taxes paid on the home; a portion of utilities, repairs and maintenance, and other household expenses; and depreciation on the business portion of the home.

108. © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 108 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta