Thought you might like to read this

[kcjenkins]

Here is a reprint of the hobby article that appeared in the October 2009 issue of Tax Reduction Letter.

If you (or someone you know) has a hobby, the information in this article will prove worthwhile.

Tax Law Obliterates Hobbies

Lawmakers hate taxpayers' hobbies. They apply the most draconian of all taxes to hobbies. If you have a hobby or are thinking of a hobby, read this article before you take step one.

Let's imagine that Congress hired you to make the most unfair and unjust income tax known to a U.S. taxpayer. How much tax would you assess? How would it work? Think about that tax. Make it as unfair as you can imagine.

Now, let's compare your most unfair tax with an income tax that actually exists in U.S. tax law.

Get Ready to Cry

For purposes of this example, let's assume that you and your spouse report more than $175,000 of taxable income before considering the taxable income and deductible expenses of your hobby. Next, let's say that your hobby has a gross income of $500,000 and expenses of $550,000 for a loss of $50,000.

Here is what current tax law does to this hobby:

The $50,000 loss is not deductible under the general rule that deductible hobby expenses may not exceed hobby income.

The $500,000 gross hobby income goes above the line on your Form 1040.

$500,000 ($550,000 minus $50,000) in hobby expenses are deducted as miscellaneous itemized deductions where they can suffer a reduction equal to 2 percent of adjusted gross income. Gross income includes the $500,000 of gross hobby income.

For purposes of the alternative minimum tax (AMT), the law disallows the $500,000 in hobby expenses and taxes the $500,000 at the 28 percent AMT rate for a tax of $140,000.

You should have tears running down your cheeks, because you are paying $140,000 in federal income taxes on a $50,000 loss. Wow! Lose money, pay taxes. This is truly outrageous—and it's true. Yikes.

Attack on the Mary Kay Lady

Jane Smith operates as a part-time Mary Kay lady. She has a gross income of $13,000 and deductible expenses of $18,000 for a net loss of $5,000. How much tax can she pay on her $5,000 loss?

John Smith, Jane's husband, earns a really good living in his law practice.

Because the Smiths have a home-equity mortgage and children, they pay the AMT without considering the Mary Kay activity; therefore, the Mary Kay activity loss triggers an additional AMT of $3,640.

Remember, Mrs. Smith lost $5,000 in her Mary Kay activity. This loss triggers an additional tax of $3,640 on the $13,000 of gross income (28 percent times $13,000). Mrs. Smith gets taxed on her gross Mary Kay income and receives the benefit of zero deductions. Mind-boggling, isn't it?

Solutions

Avoid hobbies. Make all your activities businesses. Businesses deduct all their expenses, and business losses may be carried back and forward to generate more tax benefits.

If that's not for you, then avoid hobbies that generate gross income. Note that we said "gross income." Remember, for purposes of the AMT, you pay taxes on the gross and get zero benefit from your deductions.

Who Created This Problem

The Tax Reform Act of 1986 created the tax rules that apply the AMT to hobbies. You would think that someone during the last 23 years would have fixed this draconian tax. Not so.

How the Hobby Rules Work

Rule 1: Report gross income from the hobby above the line. As an individual, you report gross hobby income on line 21 of your IRS Form 1040. [1]

In determining gross hobby income, [2]

deduct the cost of goods sold as determined using generally accepted accounting principles; and

include all gains from the sale, exchange, or other disposition of property.

Rule 2: Order the hobby deductions. If deductions exceed income, then deductions are allowed only to the extent of gross income. In determining how the deductions are allowed, you need to follow the three steps below, in the order listed: [3]

Deduct expenses such as mortgage interest and property taxes that would be allowed regardless of activity.

To the extent that gross hobby income remains after subtracting the deductions in step 1, deduct operating expenses that do not reduce the basis of assets, such as advertising, insurance, and wages.

To the extent that gross hobby income remains after applications of steps 1 and 2 above, deduct expenses that reduce the basis of assets, such as depreciation and amortization.

Rule 3: Treat hobby deductions as miscellaneous itemized deductions—a below-the-line deduction. The hobby deductions allowed in step 2 go to the miscellaneous itemized deduction "jailhouse," where

if you don't itemize your deductions, you get no tax benefit from your hobby deductions; or

if you do itemize your deductions, your hobby deductions join the category where tax law reduces deductions by 2 percent of adjusted gross income. [4]

Rule 4: Apply the AMT. The AMT on the hobby deduction works like this: Disallow all the deductions and tax the gross income. In other words, the hobby deductions that you claimed for regular tax purposes turn into taxable AMT income when computing the AMT. [5]

For most taxpayers, the AMT is a most unpleasant surprise.

Rules for Making the Activity a Business

You do not want any hobbies that generate income, because tax law can tax the income and give you zero deductions.

Solution. Make all income-generating activities businesses.

The IRS looks at nine business factors. We turned those nine factors into nine questions to which your correct answer should be either "yes" or "not applicable." Here are the nine questions: [6]

Do you carry on this activity in a businesslike manner with complete and accurate books and records?

Do you have expertise in this activity? If not, do you use outside experts or otherwise study the activity in a manner that indicates a profit motive?

Do you spend time on this activity? The more time you spend, the more this activity looks like a for-profit activity.

Do you expect appreciation in property values to produce the ultimate profits?

Have you had success doing this type of thing in the past?

Does your history of profits and losses with this activity show that you engaged in this activity for profit?

Does the profit you realize or hope to realize justify the losses incurred or expected?

Considering your other sources of income, do you need this activity to work for your well-being? (If you work at this full time and need this work to pay for your household, you pass the business test on this answer alone.)

Is your personal pleasure or recreation absent from this activity? (In other words, you are not golfing, fishing, horseback riding, woodworking, etc.)

Remember, "yes" answers increase your chances that the IRS will consider your activity a business. You don't need nine "yes" answers. You might only need one. But you need to consider the tax ramifications of a hobby versus those of a business. The ultimate answer depends on your facts and circumstances.

Endnotes

1. IRS Pub. 535, Business Expenses (2008), p. 5.

2. Reg. Section 1.183-1(e).

3. Reg. Section 1.183-1(.

4. IRC Section 67.

5. IRC Section 56((1)(A)(i).

6. Reg. Section 1.183-2(.

To see the other articles in the October 2009 issue of Tax Reduction Letter, click here.

Sincerely,

W. Murray Bradford, CPA

Publisher

Tax Reduction Letter

www.bradfordtaxinstitute.com

[jainen]

>>the most draconian of all taxes<<

Such hyperbole about this long-accepted principle damages the author's credibility. There are dozens of common techniques for avoiding the limitations on writing off personal activities, but this guy apparently gets paid to just rant so he doesn't care to mention any of that.

[kcjenkins]

Are you saying that the AMT is not Draconian?

creation by Draco (in Draco (Greek lawgiver))

Athenian lawgiver whose harsh legal code punished both trivial and serious crimes in Athens with death—hence the continued use of the word draconian to describe repressive legal measures.

[jainen]

>>Are you saying that the AMT is not Draconian? <<

No, I'm trying to AVOID such inflammatory language so the facts can be understood.

And in my understanding, a flat tax like AMT is generally considered reasonable and fair. Some people reject it in whole or in part because of political opinions about social services or income levels, but kc I have seen you post many times that such considerations are best left out of the simple equations for raising revenue.

[kcjenkins]

"AMT is generally considered reasonable and fair."

I can't believe you said that. I do not know anyone, excepting you, who understands how AMT is calculated, and thinks it is reasonable and fair. Even those who thought it was OK when it was passed no longer think it is, thanks to it's lack of indexing.

[jainen]

>>it's lack of indexing<<

It is not the tax itself that people want indexed, but the exemption from tax. The only justification for such an exemption is the idea of progressive tax rates, that there is some income level that should be hit harder than others. That is reasonable as a political theory, but is obviously not fair in the sense of everyone being treated equally under the law. AMT is fundamentally a flat tax, which says you can't avoid a fair share by claiming special tax breaks.

If you have never heard anyone speak in favor of a flat tax, you are not paying attention. Although the financial press likes to rail against AMT, Congressional studies and action continue to support it as a fair compromise.

[JohnH]

So in whose universe should property taxes and state income taxes be considered "special tax breaks" ?

[jainen]

>>in whose universe should property taxes and state income taxes be considered "special tax breaks" ? <<

Property taxes -- Renters, a third of all taxpayers

State income taxes -- Residents of Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming, a fifth of all taxpayers. Plus pretty much all low income taxpayers in every state.

[Catherine]

>>it's lack of indexing<<

It is not the tax itself that people want indexed, but the exemption from tax. The only justification for such an exemption is the idea of progressive tax rates, that there is some income level that should be hit harder than others. <snip>

You're missing the point. The indexing lacking in AMT is the indexing for INFLATION -- it is NOT fair that a tax originally meant to make sure "rich" folks paid -something- ends up hitting middle-income people, for whom it was NEVER intended, hard. But the gutless weasels in Washington don't have the testicular fortitude to fix it, because it brings in cash. So we get the annual "patches" (to stick another temporary finger in a very leaky dike) that are put in only so they keep from getting run out of their home towns on a rail.

And I support the FairTax, not a flat tax. I hear railing every year from Massachusetts taxpayers about the unfairness of the state income tax. I always point out that it's a flat tax.

[jainen]

>>the gutless weasels in Washington don't have the testicular fortitude<<

As I said, you have a reasonable political opinion. Can't you express it in ordinary language that addresses the merits of the issue rather than inflammatory ad hominem attacks on people who have a different opinion?

As YOU said, AMT is indeed indexed for inflation and has been for years. What you call a temporary finger in the dike has exactly the same desired effect as any other implementation, and it is more honest because the fiscal impact is not projected into an indefinite future.

As we both said, indexing the exemption maintains the system of assessing taxes according to economic class.

[BulldogTom]

I just have to jump in here. I cannot believe that Jainen, of all people, is arguing for a flat tax. At least I think that is what he is doing.

I like his arguments.

Here are mine in opposition: The constitution requires equal protection under the law. However, the tax law does not follow that. What other segment of law is not equally applied to all citizens? Murder is murder and the statutes apply equally to all. Extortion, rape, theft, speeding in your car, arson, contracts, --they are all applied equally to all who run afoul of them. However, the tax law is applied differently to different social classes. If you are in the poverty class, you do not have to pay taxes at all. If you are in the rich class, you fall under a completely different set of laws. The same law that provides a tax break for property taxes to a lower economic class does not apply to the rich class. And the only difference is the level of success the rich taxpayer has harvested from this country. In CA, just earn over a million in a year, and a special tax is applied to you. For what reason? Because you are rich. But doesn't the armed forces provide protection for all of us? Doesn't the fire department respond regardless of the address? The water behind the dams does not flow only to some home and not others. The canals that ship water from the delta in northern california to southern california do not only go to rich peoples homes. Every child gets to go to school for free without regard to their addresses. All of the great services the government provides go to all the citizens. Yet some do not pay anything for them. How would you like to buy a home from someone, discover there were un-disclosed problems with the home, sue the person who sold you the home under the law, and be told by the judge "Sorry, you earn too much money to avail yourself to this law. You fall under a different law. You lose because you are rich".

However, the government services for food stamps, medicaid, low income housing and social services are not available to the rich. Still the rich have to pay for them and cannot avail themselves of the benefits of the government services.

If I were to change the name in the above paragraph from rich to white and from poor to some ethnic group, no one would ever stand up for this type of law.

Why don't we have equality under the tax law? Why doesn't the same law apply to all?

Equality, it is a beautiful thing - isn't it?

Tom

Lodi, CA

[Catherine]

<snip>

Equality, it is a beautiful thing - isn't it?

Tom

Lodi, CA

Yay, Tom!!

[JohnH]

Tom:

We do have equality, but some people are more equal than others.

Government's role is to "spread it around a little", according to a recent political candidate and his sycophants.

[jainen]

>>arguing for a flat tax<<

Not at all. I believe that anyone who earns more than me (or rather, more than my wife) should naturally carry lazy net-surfers such as I. That's what make America great!

However, I am irritated at the shallow, insincere and inconsistent arguments against AMT. Does Catherine, who prefers a national sales tax, really believe that economic class should determine who pays taxes? 'Cause that's what she says. Kc, of all people, makes the same Marxist argument! John says we shouldn't even notice that property rights include the right to avoid income tax. Frankly, because of previous things these members have posted, I don't think they have really thought through the implications of such cliche arguments popularized by a muckraking press.

[Catherine]

>>arguing for a flat tax<<

Not at all. I believe that anyone who earns more than me (or rather, more than my wife) should naturally carry lazy net-surfers such as I. That's what make America great!

However, I am irritated at the shallow, insincere and inconsistent arguments against AMT. Does Catherine, who prefers a national sales tax, really believe that economic class should determine who pays taxes? 'Cause that's what she says. Kc, of all people, makes the same Marxist argument! John says we shouldn't even notice that property rights include the right to avoid income tax. Frankly, because of previous things these members have posted, I don't think they have really thought through the implications of such cliche arguments popularized by a muckraking press.

jainen, I cannot believe that you think that I am making Marxist arguments. You -must- be willfully misconstruing my remarks, as I can see NO way to accidentally do so.

I believe that ALL income taxes are diametrically opposed to the intent of the Founders, and they instituted the government to very specifically NOT tax income. Part of the reason for this was to "starve" the Federal government to keep it from encroaching on the rights of the states and the people, partly because of the disincentive to strive and achieve it becomes over time. MOST of what the Federal government does today is NOT in their purview; they have taken over the work of the states and the people and usurped powers they were very specifically NOT to have. This encroachment has been going on for over a hundred years now.

I have studied the Marxist systems - both in theory and as they exist in the real world - extensively. They do NOT work. They never WILL work. The essence of Marxism is central CONTROL of ALL aspects of the lives of the people. The essence of the Declaration of Independence and the US Constitution is individual FREEDOM and individual RESPONSIBILITY. The only people who will willfully choose the former are those who believe that the control and associated power will be theirs to wield.

With every post you make, I understand more why you have been banned from other fora.

[JohnH]

Catherine: No disagreement with your opinions on the tax system, etc, but I'd like to see you alter or delete that last sentence. jainen doesn't need me to defend him, but I think diversity of opinion is what makes this forum unique, and he's not the only person on this forum who holds those views. Personally, I learn much more from people who disagree with me than from people with whom I agree. You need iron to sharpen iron.

[TAXBILLY]

Now, now, boys and girls, let's play nice! :~)

taxbilly

[jainen]

>>you think that I am making Marxist arguments<<

Well, I certainly don't believe you are a Marxist, Catherine. But you are explaining your tax position in Marxist terms of economic class. Since you studied Marx, you know that he was an economist. (Later his views were applied politically by others to increase central control, but as you point out yourself, capitalism has been plagued by the same kind of central political control.)

If you object to "the disincentive to strive and achieve," how can you say the problem with AMT is that it should not deny deductions unless someone works hard and earns more than some calculated amount? Indexed, no less, so even if income goes up one can never join the ranks of the "rich folks." I'm not saying that's what Marx advocated--that's what he said was WRONG with capitalism. He was lying, as indeed you point out--the Founders wanted a land of freedom and opportunity without such class distinctions (at least for white males). But our financial press has drummed this Marxist language into our daily conversation--that our system is and should be based on economic class lines. Think about it.

[jainen]

>>alter or delete that last sentence. jainen doesn't need me to defend him, but I think diversity of opinion is what makes this forum unique<<

Thanks, JohnH. The title of this thread is "...to provoke thoughts." Presumably kc wanted the thoughts provoked to be on the topics in the article, rather than ad hominem attacks on forum members. My post was pretty harsh but I tried to talk only about the qualities of different tax opinions. I did use names, but only to identify those opinions.

Still, Catherine is factual in reminding us that I was banned from another forum. It happened during a discussion of the political implications of tax policy, like this one. So far, the ATX Community has been more tolerant of diversity. (The other forum was connected with a tax research product that you may find similarly narrow-minded.)

[kcjenkins]

Well, I can assure you that I am not about to ban you, Jainen, just because you disagree with me. Even when you, IMO misstate my opinions, as you did here.

I have always opposed the AMT, and my opinion has nothing to do with its lack of indexing, although I do think that was part of what made it a badly written law. My objection to it is to it's basic premise that when someone has reduced his tax burden through the lawful use of legitimate tax breaks that Congress, in their wisdom, wrote into law, they should be PUNISHED with the imposition of a tax anyway. Congress passes such tax breaks to encourage citizens to take certain economic decisions. So what moral argument can be made that certain citizens should not get to take the legal tax break, when they did the action, just because they are richer?

[JohnH]

I haven't been banned from the forum I think you are referring to, but believe it or not I have been officially reprimanded over there for stepping over the political/economic/religious line once or twice. The difference, of course, is that the owners of that forum & most others are free to make and enforce the rules as they wish, whereas I hope we can continue to enjoy a more lively and open-minded approach here since we are all co-owners in a sense. And of course I still think your position on the AMT is full of logical holes & inconsistencies, not to mention bad policy.

[jainen]

>>your position on the AMT is full of logical holes & inconsistencies<<

Yeah, I have to agree with you there. But give me a little slack, please, in the pursuit of diversity. It's mighty hard to defend AMT without a bunch of holes, you know, because as KC says it IS a poorly written law. Whether the nominal goal is worthy or not, in practice it certainly does not achieve anything anyone recognizes as reasonable or fair. Too complicated, for one thing, which is a weird thing to have to say about a flat tax compared to a progressive tax! It doesn't fit into any reliable planning scheme, so the common term "hit" is very appropriate.

But these points should lend substance to the discussion, not break it down into sound bytes and rhetoric. I just hate the concept of "middle class" in taxation. I stand by my characterization of it as Marxism, the antipathy of economic mobility. The closing years of each of the past two administrations, Democrat and Republican alike, showed that nobody is secure in an economic position. And nobody is stuck, either.

A big part of AMT is the credit, a sort of income averaging, which I think is a good thing (albeit backwards). Commentary on that is pretty subdued when it exists at all. I guess it isn't disturbing enough for selling headlines.

[Catherine]

>>you think that I am making Marxist arguments<<

Well, I certainly don't believe you are a Marxist, Catherine. But you are explaining your tax position in Marxist terms of economic class. Since you studied Marx, you know that he was an economist. (Later his views were applied politically by others to increase central control, but as you point out yourself, capitalism has been plagued by the same kind of central political control.)

If you object to "the disincentive to strive and achieve," how can you say the problem with AMT is that it should not deny deductions unless someone works hard and earns more than some calculated amount? Indexed, no less, so even if income goes up one can never join the ranks of the "rich folks." I'm not saying that's what Marx advocated--that's what he said was WRONG with capitalism. He was lying, as indeed you point out--the Founders wanted a land of freedom and opportunity without such class distinctions (at least for white males). But our financial press has drummed this Marxist language into our daily conversation--that our system is and should be based on economic class lines. Think about it.

No, not my tax position, but the -legistlative- position that was taken when AMT was passed. It has been subverted and is now being used as a tool for monetary extraction from those from whom it was never intended to affect, simply because a bunch of gutless nincompoops see a way to weasel more money out of folks without having to take a stand. I do not now nor have I every supported AMT.

I have NO problem with diverging opinions. But I DO have a problem with name-calling and with twisting another's words to form a meaning that is clearly NOT what was intended. jainen does both, frequently.

One of my dearest friends is an out-and-out socialist. We have very lively discussions and email interchanges. And neither of us EVER call the other names.

And that, JohnH, is what I was referring to. Not jainen's opinions. But the way he mis-states other's words, and that he sometimes name-calls.

jainen -- you have the right to ANY opinion, and to express that opinion. But express YOUR opinion, please.

And I'd love to talk about roses some time. You've mentioned yours a number of times, but not what types you have or whether you look for scent, color, shape, size, etc. I have three climbers that keep trying to take over the house, and one shrub that in the last few years seems to be imitating the climbers.

[BulldogTom]

I am so disapointed. I wrote a long piece for this waiting for Jainen to call me names and poke fun at my flawed logic. I got squat from him.

I am going to go pout now.

Just kidding.

Tom

Lodi, CA

[jainen]

>>a bunch of gutless nincompoops see a way to weasel more money out of folks.... But I DO have a problem with name-calling<<

I have begun my four-month project to prune and force 65 rosebushes into dormancy, modern and vintage shrub, climber, and tea varieties chosen for performance in mild climates. We prefer repeat blooming over long stems. We also choose fragrance although like many people I am not able to detect the tea scent. (I can't convince DMV that this serious disability deserves handicap license plates.)