This week, Gail answers a reader's question about the IRS's definition of a small business, and helps solve a dad's UGMA dilemma.
I was told that in order to classify an activity as a small business, you had to earn a profit for a certain number of years or it would be considered a hobby rather than a business. Is this true?
I have a small business in which I raise and train show dogs. I have had a loss the last three years doing this. I was warned by an accountant that if I didn't show a profit next year, my business would be considered a hobby and I would have to re-file the prior years' tax returns and pay the difference between what could be deducted as a business vs. a hobby.
Could you comment on this as it could be a substantial amount of money.
Lynn in Michigan
Dear Lynn -
A 'business' is defined as an activity conducted with the intention of making a profit.
The so-called "Hobby Loss Rule," limits the expenses you can deduct if the IRS determines that your involvement in an activity is more of an amusing pasttime than a business. (You can't have "business deductions" if you're not operating a "business"!)
If you earn a profit in three out of five years,you're home-free: it is presumed you are conducting this activity with the intent to make a profit. (You might call this the "proof-is-in-the-pudding" defense.)
But what if it simply takes a long time before you get to the point of profitability? Your case is a perfect example: Several years ago, you started raising and training dogs with the goal of one day earning a profit. This has not yet materialized. So is it or isn't it a "business" and are the expenses you incur tax-deductible?
According to CPA Jerold Weinstein of West Roxbury, Massachusetts, if you fail the "three out of five years" test, your situation is "not automatically a lost cause." There are some other factors the IRS can taken into consideration in determining the motive behind the activity you're engaged in.
Weinstein, a 30-year veteran in the fields of tax and investing, says the four factors which weigh most heavily are the following:
1. Is the activity conducted in a "businesslike manner?" Evidence of this would be separate accounting records, i.e you're not co-mingling business and personal money. Your business has it's own checking account and a separate phone number. You have created business cards, stationery, brochures. If you operate out of your house, there is a separate, designated a specific area just for the conduct of your business.
2. Your qualifications for operating this type of activity. What experience do you have in raising and training dogs? In other words, is it reasonable to expect a person with your background to make a profit at this activity?
3. How much time are you devoting to this activity? While there is no specific number of hours per week which mark the difference between "hobby" and "business," tax literature does say your should be spending a
"considerable" amount of time engaged in this activity for it to be considered a business.
4. The potential for the assets of the business to increase in value. This generally relates to real estate. Even if your dog-related activities do not generate a profit, perhaps the land where the kennels and training facility are located is adjacent to a new office complex. Though you're not earning a profit right now, you will when you eventually sell the business and the property associated with it.
According to the book Tax Facts Two, published by National Underwriter, the IRS will also look at "elements of personal pleasure or recreation [the taxpayer] derives from the activity." In other words, would you continue to raise and train dogs even if there were no chance of earning a living from this?
Consider this fair warning: if you continue to subtract business expenses while showing your business losing money, you are waving a red flag in the face of the IRS. Be prepared to be audited. However, if you think your answers to the questions above justify classifying your dog-related activites as a "business" despite its dismal profit picture, don't throw in the towel. (Or the leash!)
Weinstein says if your current tax advisor is getting squeamish about supporting you on this matter, you might want to find someone else to do your accounting. He suggests asking other dog breeders/traininers for referrals. You want a tax advisor who is familiar with this part of the tax code and knows how to best present your case.
So, "Go fetch!"
I opened UTMA accounts for my sons with money from their grandparents. This was done since the savings accounts the money was in was earning less than 1% interest. I invested the UTMA money in a mutual fund with a mix of 60% stock/40% bonds figuring that that would do better over the long haul.
I just read that the UTMA might hinder the amount of financial aid my sons receive when they attend college. (not for another 14 and 15 years).
My question is: Besides a 529 account, is there any other kind of account/fund that I could put additional funds into that would benefit them? Would I be better off taking the money in the UTMAs, depositing it in a mutual fund in my own name & then cashing out that account to pay for their education at a future date?
Anything you put into a "Uniform Gift to Minors Account" is considered an irrevocable gift to that child. In some states, this is called a "Uniform Transfer to Minors Account," or UTMA.) Now that you have funded UGMAs with your sons as beneficiaries, you cannot simply cash them out and invest the proceeds in your own name.
I definitely agree with you that keeping college education money in a savings account earning an interest rate of less than 1% is ridiculous -- especially since your sons have more than ten years before they'll need this money. And I like the idea of using a "balanced" fund because you have exposure to both the stock and bond markets. This means you have the opportunity to benefit when either of these markets is in favor and it also
provides diversification that can help cushion the downside if either does poorly. But you haven't improved the tax situation for your sons by moving the money into a UGMA.
With both the bank account or UGMA, earnings are taxed every year. Until a child is age 14, the first $750 his account generates is completely free of federal tax. The next $750 will be taxed based on the child's tax bracket. All earnings above $1500 will be taxed at the parents' highest marginal tax rate.
Assets in the student's name -- including a UGMA/UTMA for his benefit -- are always counted more heavily against him when it comes to eligibility for financial aid. It's too late to change that.
You could invest new money for your sons' education in an account in your name, but you, too, would pay income tax on the earnings as well as capital gains tax when you sell it. And in both cases this would be at the tax rates that apply to your income level.
Which brings up the main advantage of the 529 approach. Regular readers of this column know, I am a huge fan of these college savings plans, as evidenced in this column and this one. Gains earned by the investments inside a 529 are completely free of federal tax provided they are withdrawn to pay for qualified higher education expenses.
There's a way to get most of the benefits of a 529 plan even though your sons' money is currently in UGMAs: It involves liquidating the mutual fund the UGMAs are currently invested in and moving the proceeds into two 529 plans -- titled in the name of each UGMA. (By law, investments in a 529 can only be made in cash, that's why they've got to be sold if you want to use this strategy.)
Most 529 plans offer a variety of accounts you can invest in, including "balanced" funds. Or, you can create your own by dividing the money between a stock and bond fund according to the ratio (60:40) that a balanced fund typically uses.
An UGMA trust for each son would still exist. It would own the 529 account until that son reached the age of majority (generally 18 or 21), when he could do what he wanted with the money.
Even though your sons will gain control of their accounts at some point (a major downfall of all UGMA/UTMA accounts), investing the UGMA assets in a 529 plan is still an improvement. Assuming the money is eventually used for college, this strategy eliminates all federal taxes -- both the annual taxation of earnings, as well as capital gains tax when the assets are liquidated.
Of course, if one of your sons decides not to attend college and figures he's going to cash in his UGMA to throw one heck of a party, the tax penalties on a 529 should make him think twice: withdrawals of earnings which are not used for "qualified" college expenses (tuition, room & board, books, fees, supplies) are subject to ordinary income tax, plus a 10% penalty. Just might be enough of a deterrent that he'll head off to school, after all!
You're on the right track, Dad!
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