Starting A New Business

Better Left Unsaid

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Material Participation

A trade or businesses is a passive activity if the taxpayer does not materially participate.  The taxpayer materially participates if and only if he or she meets one of the following seven tests.

1.      The taxpayer works 500 hours or more during the year in the activity

2. The taxpayer does substantially all the work in the activity.
3. The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
4. The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
5. The taxpayer materially participated in the activity in any 5 of the prior 10 years.
6. The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.
7. Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year.  However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.^[3]

Note: The first four tests look to a set number of hours of participation in the tax year.  The next two tests look to material participation in prior tax years.  The final test looks to the facts and circumstances, but is highly restrictive.

Material participation applies to income as well as to losses.  One of the purposes of the last four material participation tests is to prevent the taxpayer from “failing” material participation when the activity generates income instead of losses.

500 Hours

If the taxpayer participates more than 500 hours during the year in a business, income or loss from the activity will be non-passive.  Participation of both spouses is counted, but not participation of the children or employees.

Participation in operations must be regular, continuous, and substantial.

Examination Techniques:

The examiner should determine whether the quantity of time documented is reasonable in light of other obligations.

• Review W-2s and other non-passive activities.  Does it seem likely that the taxpayer could spend 500 hours on the activity in light of other employment obligations?
• Ask questions on taxpayer activity time early in the examination.  Establish time the taxpayer spends on all activities during the initial interview if possible.  See exhibit with log at the end of the chapter.
• Determine the location of each activity.  If located far from the taxpayer’s residence, how likely is the taxpayer to have spent substantial time on the activity?

Substantially All

Stated simply, if the taxpayer does most of the work, income or loss will be non-passive.  The involvement in the activity of an employee or non-owner could cause the taxpayer to fail this test.

Note: There is no specific number of hours associated with this test.  In addition, the term “substantially” is not defined in the regulations.

100 Hours

If a taxpayer participates in an activity for more than 100 hours and no other individual participates more than the taxpayer (including any employee or non-owner), income or losses from the activity are non-passive.

Examination Techniques:

• Be alert to employees who are managing the activity, indicating the taxpayer deducting the losses may not be materially participating (particularly on Form 1040 Schedules C & F).
• When reviewing taxpayer hours, watch for “investor” activities (Reg. § 1.469-5T(f)(2)(ii)).  The taxpayer must be involved in the activity’s day-to-day management or operations.  Hours spent toward reviewing financial statements, preparing analysis for personal use, and monitoring the activity in a non-managerial capacity do not count.

Does material participation matter? You bet it does. It means the difference between being able to deduct a business loss or having to defer it to future years when it may not be worth as much.

Retirement Planning

Once the decision is made to start a business it is probably a good time to start thinking about retirement. It may seem early but any advisor will, or at least should, tell you that it is much easier to put a little aside now rather than wait and have to try and put a lot aside later

How much will you need?

Everyone is different with dif­ferent needs, so throwing out a specific number would not be very helpful. The only correct answer to “how much?” is “it depends.” Some of the factors that you need to consider include your current earn­ings level, spending pattern, debt level, and obligations. That last factor could be a big one, as it includes children (many baby boomers still have relatively young children, despite being close to “retirement” age) and parents who might need extra help. In addi­tion to the current factors, you also need to consider what you expect to happen on all of the above issues in the future.

Figuring out what’s going on today is the easy part, but how do you figure out what will happen after you retire? The answers are almost limitless. For example, if you live in a $500,000 home, are you going to stay there or sell it? If you sell, you could buy a smaller home and bank the cash dif­ference. You could also le­verage yourself up with a mortgage and buy a dream home worth millions. The direc­tion you go in would, obviously, have a ma­terial impact on your financial needs.

Many people in this country don’t have enough money put aside for re­tirement. Some may have $100,000 or more in savings. Even for a frugal person, that may not last more than a few years. You can add Social Security to the mix and home equity to brighten the picture, but that doesn’t change the situation materially.

Social Security is only meant as a backstop against pov­erty. Although it may live up to that expectation, most people expect more of their golden years. With regard to home eq­uity, unless you plan on living on the street, you’ll still need a place for yourselves once you retire. As such, you can only count on a portion of that “equity” being available. In fact, a large percentage of people nearing re­tirement still have hefty mortgage payments, as they refinanced when rates fell. That would be good if they saved and invested the money, but most spent it.

The best answer to the question of “how much?” is probably “it depends, but it’s likely more than you have saved right now.”

That’s the fact most people have to face. The only viable solution is to ratchet up the savings rate. That means maxing out tax advantaged accounts available through work (4Olks) or on your own (IRAs), and saving on your own through various investment vehicles such as stocks and bonds. One thing to remember, don’t walk away and leave “money on the table.” If your company matches any portion of your contribution to a retirement plan you should be putting money into the plan. The money your company matches is free—why wouldn’t you take advantage of that found money?

Another point to consider is that you are likely to live 20 or more years in retirement, so you will need to be more aggressive than past generations when it comes to investing your assets. If you have too heavy an alloca­tion to fixed-income investments (bonds), you could outlive your money, leaving you only with Social Security.

So, in the end, the answer to “how much do you need?” is “It depends, but you probably need more than you have now so you should save as much as you can between now and when you retire.” That may not be what you wanted to hear, but it’s the truth.

Like the A&E Channel it may be time well spent to sit and talk to your tax and/or financial advisor about retirement planning.

Nice try

A federal judge sentenced Richard Hatch to 51 months in prison for evading income taxes. In January, a jury found him guilty of tax evasion and filing a false return for not reporting to the IRS about $1,428,000 that he earned from the “Survivor” television series and other sources. United States Attorney Robert Clark Corrente and Eileen J. O’Connor, Assistant Attorney General for the Department of Justice Tax Division, jointly announced the sentence, which Chief U.S. District Court Judge Ernest C. Torres imposed today in U.S. District Court. Judge Torres enhanced Hatch’s sentence for obstruction of justice. The government asked for that enhancement, arguing that Hatch perjured himself during the trial and failed to disclose assets to the Probation Office. Judge Torres also ordered Hatch to pay taxes that he owes for 2000 and 2001, which the IRS has calculated at $474,971, plus interest and penalties. “In addition to punishing this defendant, this sentence should serve as a warning to others who might think of dodging their tax obligations,” U.S. Attorney Corrente said. “Paying taxes is an ordeal but it is every citizen’s obligation to pay them honestly and fully.” “Our nation’s federal tax system is not a reality show to be outwitted, it is a reality, period," said Eileen J. O'Connor, Assistant Attorney General of the Justice Department's Tax Division. "The Department of Justice is working vigorously to vindicate the interests of law-abiding taxpayers: tax cheats will be found out, prosecuted, and punished."

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Business or Hobby?

Not-for-Profit Activities

If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income. Activities you do as a hobby, or mainly for sport or recreation, are often not entered into for profit. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations. There are nine factors used in determining whether an activity is a business or hobby.

1. THE MANNER IN WHICH THE TAXPAYER CARRIES ON THE ACTIVITY.
Is the venture carried on in a businesslike manner? Are separate and accurate books and records maintained? Are new techniques and methods of operation adopted and unprofitable strategies abandoned?

The courts have also cited failures to carry on the venture in a business-like manner in determining a business to be a hobby. Sound business practices, having a plan to guide business decisions toward a profitable operation and modifying methods of carrying on the operation, which have not been, successful are key elements for the courts in deciding hobby loss cases.

2. THE EXPERTISE OF THE TAXPAYER OR HIS ADVISORS.
The owner’s knowledge or effort to learn how to manage a successful enterprise has been considered by the courts in several cases.

3. THE TIME AND EFFORT EXPENDED BY THE TAXPAYER IN CARRYING ON THE ACTIVITY.
The time devoted to the activity, either in planning and supervising it or in performing labor connected with the operation of a business, is an important consideration in determining whether it is a business or a hobby. If the taxpayer devotes considerable time to the venture, including partial or total withdrawal from another occupation, this will be considered evidence that the business is one engaged in profit. If there is no substantial time devoted by the taxpayer but he employs qualified people to run it for him, the lack of time he spends on it will not necessarily indicate the lack of profit objective.

4. EXPECTATION THAT THE ASSETS USED IN ACTIVITY WILL INCREASE IN VALUE.
This factor has not been a major element in previous court decisions, but the expectation of appreciation of assets in establishing a plan for profitable operation of a business can be important in proving a profit motive. Such assets include real estate or other assets of the business.

5. THE SUCCESS OF THE TAXPAYER IN OTHER ACTIVITIES.
If the taxpayer has a history of turning unprofitable activities into money-making enterprises, this is evidence that current losses in a venture may eventually result in future profits. However, the courts in recent hobby loss cases have not considered this factor.

6. THE TAXPAYER'S HISTORY OF INCOME OR LOSSES IN THIS ACTIVITY.
The profitable operation of a business activity obviously is sound evidence that it is engaged in for profit, but the reverse is not necessarily true. Losses during the first years of an enterprise are not unusual and may not be an indication it is not engaged in for profit.

If the losses continue well beyond the early years, this can be evidence that it is not an activity engaged in for profit. However, this is not necessarily a controlling factor. The taxpayer may be able to demonstrate mitigating circumstances, which have caused the continued losses.

To the extent such events have caused what appeared to be a successful plan of operation to go awry, the courts have considered them important in determining whether a business venture was a business or a hobby. For that reason, good records again are emphasized.

7. THE AMOUNT OF OCCASIONAL PROFITS, IF ANY, WHICH ARE EARNED.
As mentioned earlier, achieving two profit years during a five year period will not necessarily assure that an activity will be judged to be engaged in for profit. If the two profit years are small in comparison to the amount of losses in other years, or in relation to the size of the taxpayer's investment, the IRS and the courts may still find that the activity was not engaged in for profit.

The reverse is also true. A substantial profit year in relation to a number of small losses or in relation to the limited investment in the operation would tend to buttress in the taxpayer's position that he was engaged in the activity for profit.

8.  THE FINANCIAL STATUS OF THE TAXPAYER.
According to the regulations, the lack of substantial income from other sources will be in your favor in determining whether your venture is a business or a hobby. On the other hand, a large income from other sources may weigh against you. The degree of personal pleasure or recreation you derive from your activity and the fact that the losses create substantial tax benefits will be taken into consideration in weighing this factor.

Some IRS agents seem to place considerable emphasis on this factor. To these agents large income or capital seems to be akin to waving a red flag in front of a bull. Fortunately, the courts generally do not share the IRS view. As an example, one court noted the taxpayer "...surely could have found a venture far less demanding of his physical and financial energies in which to "shelter" a portion of his income."

9. ELEMENTS OF PERSONAL PLEASURE OR RECREATION.
The regulations note that the personal motives may indicate the activity was not engaged in for profit, particularly if it provides recreation or pleasure for the taxpayer. This does not mean the taxpayer should not enjoy the activity, but the motive for carrying on the enterprise must include an objective of making a profit. So long as the other factors indicate a profit motive, personal pleasure will not cause the activity to be classified as a hobby. However, if the previous factors do not clearly substantiate a profit motive and the taxpayer or his family clearly derive enjoyment from the operation, this could weigh as a negative factor.

SUMMARY:
It should be emphasized that the IRS does not add up the number of positive and negative factors and base its decision on a mathematical result. In addition, the courts appear to have placed greater emphasis on some of the factors than they have on others.

Most experts have concluded that one of the most crucial elements is the manner in which the taxpayer carries on the activity. The failure to maintain adequate, accurate books and records has been the key to several rulings that an activity was a hobby. Further, the lack of these records will make the task of reaching a positive conclusion on other factors more difficult. While good records alone will not insure the activity is engaged in for profit, the absence greatly increases the chance that the operation will be judged a hobby. As with all tax issues, the facts and circumstances of each individual operation must be considered and you should consult your tax accountant or an accountant familiar with your activity for advice and specific situations.

Presumption of profit.   An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least 2 of the last 7 tax years, including the current year. The activity must be substantially the same for each year within this period. You have a profit when the gross income from an activity exceeds the deductions. If a taxpayer dies before the end of the 5-year (or 7-year) period, the “test” period ends on the date of the taxpayer's death. If your business or investment activity passes this 3- (or 2-) years-of-profit test, the IRS will presume it is carried on for profit. This means the limits discussed here will not apply. You can take all your business deductions from the activity, even for the years that you have a loss. You can rely on this presumption unless the IRS later shows it to be invalid.

Limit on Deductions

If your activity is not carried on for profit, take deductions in the following order and only to the extent stated in the three categories. If you are an individual, these deductions may be taken only if you itemize. These deductions may be taken on Schedule A (Form 1040).

Category 1.   Deductions you can take for personal as well as for business activities are allowed in full. For individuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses, belong in this category. Deduct them on the appropriate lines of Schedule A (Form 1040). You can deduct a casualty loss on property you own for personal use only to the extent it is more than $100 and exceeds 10% of your adjusted gross income. See Publication 547 for more information on casualty losses. For the limits that apply to mortgage interest, see Publication 936.

Category 2.   Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent your gross income from the activity is more than your deductions under the first category. Most business deductions, such as those for advertising, insurance premiums, interest, utilities, and wages, belong in this category.

Category 3.   Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity exceeds the deductions you take under the first two categories. Deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in category (1) belong in this category. Where more than one asset is involved, allocate depreciation and these other deductions proportionally.

The Limited Liability Company (LLC)

When I was an accountant for IBM, I tried to create a hybrid entry. I called it a nebit. It wasn’t a debit and it wasn’t a credit. It was somewhere in between. It was to be used when either a debit or credit wasn’t exactly right. You could use it when the trial balance didn’t or when you couldn’t find that $.10 you were out of balance. This will probably not come as a surprise but the nebit is not a part of any accounting system today.

If you are looking for an entity that falls between a partnership and a corporation, maybe the Limited Liability Company (LLC) is what you seek. The LLC provides the liability protection of a corporation with the profit sharing flexibility of the partnership. Like the corporation, the LLC is a state law creation. It is formed by filing articles of organization with the appropriate state organization, usually the state secretary of state. The owners of a LLC are called members. Like the corporation, you get to chose, with the IRS, how the LLC is taxed. It can be treated like a partnership or a corporation but you must make the election. If you are a single member LLC, the partnership election is not available. You are either treated as a sole proprietor or a corporation. If you chose corporation, you get to make another election, are you going to be treated as a C Corp or an S Corp.

The Corporation

If the sole proprietor or partnership doesn’t fit your new business, maybe the corporation will. Forming a corporation requires the filing of articles of incorporation in a state, usually with the secretary of state, and making an election with the IRS as to the type corporation you want to use for tax purposes. Corporations provide liability protection for its shareholders. In the eyes of civil law, corporations are entities just like you and I are. Since they are entities, they can be sued and have judgments levied against them. Only corporate assets can be used to satisfy those judgments. Assets of the shareholders are not available to settle corporate judgments. That is the general rule. Now, as Paul Harvey would say, for the rest of the story. If you form a corporation to limit your personal liability, you want to be sure that you function as a corporation. That means that you should do everything that a corporation is expected to do, think IBM, AT&T, and General Motors etc. You need to issue stock, hold board meetings, even if you’re the only member. Hopefully if you’re the only member, you’ll be able to pass whatever resolutions you submit to yourself. If you can’t then this may not the right form of business for you. You should also open a business checking account. Those are some of the things you should do. One thing you shouldn’t do is plan to hold a stockholders meeting in some exotic location and taking the whole family without talking to your tax advisor first. You might have a hard time explaining that one to our friends at the IRS. Even more difficult would be having them buy it. One choice you’ll have to make if you decide to incorporate is whether to elect the C Corp, S Corp or the Personal Corporation (PC.)

The C Corp files a tax return and pays taxes on its profits. It also accumulates and carries forward any losses it may have. The big disadvantage to the C Corp is that  if the corporation has a profit and pays the tax on that profit and then distributes it to the shareholders as a dividends, the shareholders have to pay tax on the same income again.

The S Corp files a tax return but usually does not pay any tax on its profits. The profits, or loss, is passed along to the shareholders to report on their individual income tax return. The S Corp cannot

·        have more than 100 shareholders.

·        a shareholder that is not an individual (some exceptions)

·        a shareholder that is a non-resident alien

·        more than one class of stock

The Partnership

Like the sole proprietor, a partnership does not require filing any documents to formally adopt. However, because there is more than one owner it is probably a good idea to have a formal partnership agreement that spells out the duties and responsibilities of each of the partners. In a partnership, there are two types of partners, the general partner and the limited partner. The general partner is usually active in the day to day management of the partnership business. One of the key advantages to the partnership choice of entity is that the partners can be equal owners of the business but can agree to share profit or loss in any ratio they decide. So if there are two partners, they can be 50-50% owners but can agree to share the profit/loss 70-30%, 80-20%, 65-35%, etc. The downside to being a general partner is that they are liable for partnership liabilities. Limited partners, on the other hand, normally have no input or say in the daily management of the partnership business. But they also have no exposure to partnership liability.