Whittenburg Gerald E., Altus-Buller Martha. Income Tax Fundamentals
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SECTION 4.12
HOBBY LOSSES
If a taxpayer enters into an activity without a profit motive, the tax law limits the amount
of tax deductions available. Under the hobby loss provisions, a taxpayer may not show a
loss from an activity that is not engaged in for profit. For example, an activity that might
cause a dentist taxpayer problems is breeding race horses on the weekend. The IRS might
contend that the activity was for personal enjoyment and disallow any loss for tax pur-
poses. Despite the limitation on losses, any profits from hobbies must be included in tax-
able income.
Operational Rules
Individual taxpayers (o r S corporations) can avoid the hobby loss rules if they can show
that the activity was condu cted with the intent to earn a profit. To determine whether
the activity was engaged i n for profit, the IRS will look at the following factors:
1. Whether the activity is conducted like a business,
2. The expertise of the taxpayer,
3. The time and effort expended,
4. Previous success of the taxpayer in similar activities,
5. Income and loss history from the activity,
6. Relationship of income to losses in the activity,
7. Financial status of the taxpayer, and
8. Elements of personal recreation in the activity.
The tax law provides a rebuttable presumption that if an activity shows a profit for 3 of
the 5 previous years (2 of the 7 previous years for activities involving horses), the activity
is engaged in for profit. For example, if an activity shows a profit for 3 of the previous
5 years, it is presumed to be a trade or business,andtheIRSmustestablishthatitisa
hobby.
Loss Limitations
For a business activity that is not a hobby, there is no limitation on the amount of expenses
allocable to the activity that the taxpayer may claim as deductions against the income of the
activity. If an activity is determined to be a hobby, it is subject to the hobby loss rules and
expenses may be allowed as deductions only to the extent of income from the activity.
Expenses otherwise deductible on Schedule A, such as certain interest (e.g ., home mort-
gage interest) and taxes, may be allowed without regard to the nature of the activity. There-
fore, a taxpayer could have a loss on a hobby to the extent the amount of otherwise
deductible interest and taxes paid exceeds the amount of income from the activity.
Other allowed expenses attributable to the hobby activity are considered miscellaneous
itemized deductions, subject to the 2 percent of adjusted gross income limitation.
EXAMPLE Fred, the president of a bank, decides that he wants to be a famous
wine maker. He has the following expenses related to this activity:
Depreciation on wine-making equipmen t $2,000
Personal property taxes on equipment 2,500
Wine-making supplies 4,600
During the year, Fred sells 200 cases of wine for $7,500. If the
activity is not a hobby, then Fred may take a loss, against his other
Section 4.12
Hobby Losses 4-29
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income, of $1,600 ($7,500 $2,000 $2,500 $4,600). However, if
the activity is deemed to be a hobby, the deductions are limited to
the income from the activity. Fred would be allowed to deduct the
property taxes of $2,500 which would leave income of $5,000. Only
$5,000 of the $6,600 of depreci ation and supplies is deductible (sub-
ject to the limitation on miscellaneous itemized deductions). N
KEY POINTS
Learning Objectives Key Points
LO 4.1:
Classify self-employed and
employee expense deductions for
adjusted gross income and from
adjusted gross income.
Business expenses incurred by an employee are generally considered miscellaneous itemized
deductions, subject to the 2 percent of adjusted gross income limitation.
Accountable-plan reimbursed employee business expenses may be treated as deductions in
arriving at adjusted gross income.
An accountable plan is one that requires the employee to substantiate expenses to the
employer and to return amounts in excess of the substantiated amounts.
LO 4.2:
Identify the requirements for
deducting travel and transportation
expenses and be able to complete
Form 2106.
Travel expenses are defined as ordinary and necessary expenses incurred in traveling away
from home in pursuit of the taxpayer’s trade or business.
Deductible travel expenses include the cost of such items as meals, lodging, taxis, tips, and
laundry.
A taxpayer must be away from home ‘‘overnight’’ in order to deduct travel expenses. Over-
night is a period of time longer than an ordinary workday in which rest or relief from work
is required. Also, the taxpayer must be away from his or her ‘‘tax home’’ to be on travel
status.
Taxpayers must substantiate the following: the amount of each separate expenditure, the
dates of departure and return for each trip and the number of business days on the trip,
the destination or locality of the travel, and the business reason for the travel.
As an alternative to reporting actual expenses, a per diem method may be used in certain
circumstances.
Deductible transportation expenses include travel by airplane, rail, bus, and auto.
If the taxpayer works at two or more jobs during the same day, he or she may deduct the
cost of going from one job to the other or from one business location to another.
Self-Study Problem 4.12
Linda is a CPA who decides that she wants to be an artist. During 2010, she
sells $250 worth of paintings and incurs the following expenses:
Painting supplies $ 300
Transportation to locat ions for painting 2,500
If this activity is deemed to be a hobby, what amount of the expenses may
Linda deduct on her 2010 tax return?
$ ____________
4-30 Chapter 4
Business Income and Expenses, Part II
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
LO 4.3:
Ascertain when a home office
deduction may be claimed and
how the deduction is computed.
A home office is generally not deductible. However, there are four exceptions to the general
rule.
A home office deduction is allowed if the home office is used on a regular basis
and exclusively as the taxpayer’s principal place of business. An employee may qualify
under this exception, provided the business use of his or her home office is for
‘‘the convenience of the employer’’ when the employer does not provide a regular
office.
A home office deduction is allowed if the home office is used exclusively and on a regular
basis by patients, clients, or customers in meetings or dealings with the taxpayer in the nor-
mal course of a trade or business.
The deduction of home office expenses is allowed if the home office is a separate structure
not attached to the dwelling unit and is used exclusively and on a regular basis in the tax-
payer’s trade or business.
A home office deduction of a portion of the cost of a dwelling unit is allowed if it is used
on a regular basis for the storage of business inventory or product samples.
The home office deduction is limited by the amount of net income from the associated
trade or business.
LO 4.4:
Determine the requirements for
claiming other common business
expenses such as entertainment,
education, uniforms, and business
gifts.
Self-employed taxpayers and employees are allowed deductions for 50 percent of the cost
of entertainment incurred in connection with their trade or business.
To be deductible, entertainment expenses must be (1) directly related to or (2) associated
with the active conduct of the taxpayer’s trade or business.
Expenses directly related to the taxpayer’s trade or business are costs related to an actual
business meeting, such as the expense of a sales luncheon where a salesperson is making
a sale to a client.
Expenses associated with the conduct of the taxpayer’s trade or business are generally
those expenses that serve a specific business purpose. The entertainment must take place
immediately before or after a bona fide business discussion.
To be deductible as a business expense, education expenditures must be paid to meet
the requirements of the taxpayer’s employer or the requirements of law or regulation
for keeping the taxpayer’s salary, status, or job, or the expenses must be paid to
maintain or improve existing skills required in performing the duties of the taxpayer’s
work.
Professionals may deduct dues and the cost of subscriptions and publications. Included are
items such as membership to the local bar for a lawyer, dues to the AICPA for an accoun-
tant, and the cost of subscriptions to any journal that is directly related to the taxpayer’s
profession.
In order to be deductible, clothing or uniforms must (1) be required as a condition of
employment and (2) not be suitable for everyday use.
Taxpayers are allowed a deduction for business gifts up to $25 per year per donee. For
purposes of this limitation, a husband and wife count as one donee, unless the husband
and wife both are clients.
To deduct entertainment expenses and business gifts, taxpayers must be able to substantiate
the deduction. The four items that must be substantiated are 1) amount of the expense,
2) time and place (entertainment) or date and description (gifts), 3) business purpose, and
4) business relationship.
LO 4.5:
Complete a basic Schedule C
(Profit or Loss from Business).
Taxpayers who operate a business or practice a profession as a sole proprietorship must file
a Schedule C (long form) or a Schedule C-EZ (short form) to report the net profit or loss
from the sole proprietorship.
If the taxpayer cannot meet the requirements for filing the simple Schedule C-EZ, then he
or she must file a standard Schedule C.
Schedule C filers such as sole proprietors and independent contractors with net earnings of
$400 or more must pay a self-employment tax calculated on Schedule SE with their Form
1040. See Chapter 9 for more detailed information.
Section 4.12
Hobby Losses 4-31
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Reinforce the tax information covered in this chapter by completing the online
interactive tutorials located at the Income Tax Fundamentals Web site:
www.cengagebrain.com.
LO 4.6:
Understand the special rules appli-
cable to moving expenses.
To qualify for the moving expense deduction, the taxpayer must change job sites, although
the taxpayer does not have to change employers. A job transfer with the same employer
meets this test.
The taxpayer must move a certain minimum distance. The distance from the taxpayer’s
former residence to the new job location must be at least 50 miles or more than the
distance from the former residence to the former job location.
The taxpayer must remain at the new job location for a certain period of time. Generally,
employees must work at least 39 weeks at the new job location during the 12 months fol-
lowing the move.
LO 4.7:
Apply the factors used to deter-
mine whether an activity is a
hobby, and understand the tax
treatment of hobby losses.
Under the hobby loss provisions, a taxpayer may not show a loss from an activity that is
not engaged in for profit.
To determine whether the activity was engaged in for profit, the IRS will look at numerous
factors including whether the activity is conducted like a business.
QUESTIONS and PROBLEMS
GROUP 1:
MULTIPLE CHOICE QUESTIONS
.............................................. .............................................. .
LO 4.1
1. Which of the following statements is true with regard to the classification of
employment-related expenses?
a. A self-employed taxpayer’s business travel expenses are deductible as itemized
deductions.
b. Reimbursed employee business expenses are always deductible as deductions for
adjusted gross income.
c. Unreimbursed employee business expe nses are deductible as deductions for
adjusted gross income.
d. Unreimbursed employee business expe nses are deductible as deductions from
adjusted gross income.
e. All of the above are true.
LO 4.5
2. What form does a self-employed sole proprietor usually use to report income and
expenses from business?
a. Schedule D
b. Schedule A, Miscellaneous Itemized Deductions
c. Schedule C
4-32 Chapter 4
Business Income and Expenses, Part II
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
d. Form 2106, Employee Business Expenses
e. None of the above
LO 4.1
3. What form does an emp loyee use to report expenses that are fully reimbursed by an
employer under an accountable plan?
a. Schedule D
b. Schedule A, Miscellaneous Itemized Deductions
c. Schedule C
d. Form 2106, Employee Business Expenses
e. No form; the expenses are not reported as income to the employee, so they are not
deducted on an IRS form in the employee’s tax return.
LO 4.2
4. Which of the following taxpayers is entitled to a travel expense deduction?
a. An employee, who worked in the Salt Lake City plant of a company, who is assigned
to the Denver plant of the company for 4 years
b. An employee who travels between several business locations within the same city
each day
c. A manager of a chain of department stores who works in the main store 3 weeks out
of every month and visits distant branch locations on overnight trips during the
remainder of the month
d. An employee who resigns from his current job and accepts a new job in a city 500
miles away from his current residence
e. A bank employee who travels to a branch office for a couple of hours of work and
decides to stay overnight to attend a play
LO 4.2
5. Which of the following expenses incurred while the taxpayer is away from home ‘‘over-
night’’ is not included as a travel expense?
a. Laundry expenses
b. Transportation expenses
c. Meal expenses
d. Business gifts
e. Lodging expenses
LO 4.2
6. Under the high-low method, the federal per diem amount given in the text for 2010 for
a high-cost locality for travel in the United States is:
a. $148 per day
b. $258 per day
c. $204 per day
d. $140 per day
e. Some other amount
LO 4.3
7. Kathy is a self-employed taxpayer working exclusively from her home office. Before the
home office deduction, Kathy has $3,000 of net income. Her allocable home office expenses
are $5,000 in total. How are the home office expenses treated on her current year tax return?
a. All home office expenses may be deducted, resulting in a business loss of $2,000.
b. Only $3,000 of home office expenses may be deducted, resulting in net business
income of zero. None of the extra $2,000 of home office expenses may be carried
forward or deducted.
c. Only $3,000 of home office expenses may be deducted, resulting in net business
income of zero. The extra $2,000 of home office expenses may be carried forward
and deducted in a future year against home office income.
d. None of the home office expenses may be deducted since Kathy’s income is too low.
Questions and Problems 4-33
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LO 4.2
8. Joe is a self-employed information technology consultant. He tak es a trip to Chicago
primarily for business. He takes two personal days to go to museums and see the sights
of Chicago. How should he treat the expenses related to this trip?
a. One hundred percent of the trip should be deducted as a business expense since the
trip was primarily for business.
b. Fifty percent of the trip should be deducted as a business expense since the IRS lim-
its such business expenses to 50 percent of the actual cost.
c. The cost of all of the airfare and the business days should be deducted, whi le the
cost of the personal days are not deductible.
d. None of the expenses are deductible since there was an element of personal enjoy-
ment in the trip.
LO 4.2
9. Which of the following taxpayers may use the standard mileage method of calculating
transportation costs?
a. A taxi driver who owns her own taxi
b. A taxpayer who used accelerated depreciation on his automobile
c. A business executive who owns and operates six different automobiles
d. An attorney who uses his Porsche for calling on clients
e. None of the above
LO 4.4
10. Which of the following is not deductible by the taxpayer?
a. A subscription to The CPA Journal by a CPA
b. A subscription to The Yale Medical Journal by a doctor
c. A subscription to Financial Management by a chief financial officer
d. A subscription to The Harvard Law Review by a lawyer
e. All of the above are deductible
LO 4.3
11. Which of the following taxpayers qualifies for a home office deduction?
a. An attorney who is employed by a law firm and has a home office in which to read
cases
b. A doctor who has a regular office downtown and a library at home to store medical
journals
c. An accounting student who maintains a home office used exclusively to prepare tax
returns
d. A nurse who maintains a home office to pay bills and read nursing journals
e. A corporate president who uses his home office to entertain friends and
customers
LO 4.3
12. Carol maintains an office in her home where she conducts a dressmaking business.
During the year she collects $4,000 from sales, pays $1,300 for various materials
and supplies, and properly allocates $2,500 of rent expense and $500 of her utilities
expense to the use of her home office. What amount of the rent and utilities expense
may Carol deduct in the current year in computin g her net income or loss from the
dressmaking business?
a. $0
b. $3,000
c. $500
d. $2,500
e. $2,700
4-34 Chapter 4
Business Income and Expenses, Part II
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Questions and Problems 4-35
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
4-36 Chapter 4
Business Income and Expenses, Part II
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
LO 4.4
13. Which of the following expenses is deductible as an entertainment expense?
a. The depreciation on an airplane used to entertain customers
b. The cost of a hunting camp used to entertain customers
c. The dues of a racket club used to keep in shape
d. The cost of a cocktail party for clients paid for by a computer salesman at a com-
puter fair
e. The cost of a meal at the taxpayer’s country club with a potential client during
which they discussed golf
LO 4.4
14. Which of the following taxpayers may not deduct the listed educational expenses?
a. A CPA who attends a course to review for the real estate agents’ exam
b. A corporate president who attends a manageme nt course at a local university
c. An attorney who attends a course on computing legal damages
d. A real estate broker who attends a college course on real estate law
e. All of the above are deductible
LO 4.4
15. Which of the following employees may deduct the cost of a uniform?
a. A lawyer who is required by her employer to wear a business suit
b. A furnace repairma n who must wear overalls while on the job
c. A nurse who can wear casual clothes while on duty
d. A marine who must purchase uniforms for on-duty and off-duty hours
e. A cheerleader for the San Diego Chargers football team who purchases her own
costume
LO 4.4
16. Which of the following business gifts are fully deductible?
a. A gift to a client costing $35
b. A gift to an employee, for 10 years of continued service, costing $250
c. A gift to a client and her nonclient spouse costing $45
d. A gift to an employee, for not having an on-the-job injury for 25 years, costing
$1,650
e. None of the above are fully deductible
LO 4.5
17. In the current year, Mary started a profitable housekeeping business as a sole propri-
etor. She has ten housekeepers working for her and spends her time selling their serv-
ices and coordinating her employees’ time. Mary made $50,000 in her first year of
operations. In addition to fi ling a Sc hedule C to report her business earnings, Mary
must also file:
a. Schedule A
b. Schedule D
c. Schedule SE
d. Schedule B
e. None of the above
LO 4.5
18. Daniel is a self-employed consultant. Until this year he was always an employee. He
comes to discuss his new business with you. As his tax accountant, you should:
a. Discuss setting up a good record keeping system for his new business
b. Discuss the substantiation requirements for meals and entertainment
c. Discuss the self-employment tax, as well as the income tax, on business earnings in
order to help Daniel estimate what he might owe in taxes for the year
d. Discuss the rules for deducting automobile expenses
e. Discuss all of the above
Questions and Problems 4-37
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LO 4.6
19. All of the following are deductible as moving expenses in 2010, except:
a. The cost of moving household goods
b. Transportation to the new job location
c. Packing expenses
d. Lodging during the move
e. All of the above are deductible moving expenses
LO 4.7
20. Which of the following factors is not considered by the IRS in determining whether an
activity is a hobby?
a. Whether the activity is conducted like a business
b. The time and effort expended by the taxpayer
c. Elements of personal recreation in the activity
d. Financial status of the taxpayer
e. All of the above are considered to determine if an activity is a hobby
GROUP 2:
PROBLEMS
.............................................. .............................................. .
LO 4.1 1. George is employed as a sales manager for a computer manufacturer. His em-
ployer does not have an accountable expense reimbursement plan. George paid
for $3,00 0 of travel expenses. How will the travel expenses be treated in George’s
tax return?
_________________________________________________ ________________________
_________________________________________________ ________________________
_________________________________________________ ________________________
LO 4.2 2. Joan is a self-employed attorney in New York City. Joan took a trip to San Diego,
CA, primarily for business, to consult with a client and take a short vacation. On
the trip, Joan incurred the following expenses:
Airfare to and from San Diego $ 575
Hotel charges while on business 340
Meals while on business 210
Car rental while on business 120
Hotel charges while on vacation 460
Meals while on vacation 290
Car rental while on vacation
180
Total
$2,175
Calculate Joan’s travel expense deduction for the trip, assuming the trip was made
in 2010.
$ ____________
LO 4.2 3. Go to the IRS Web site (www.irs.gov) and find the most recent IRS Publication 1542,
Per Diem Rates. What is the maximum per diem rate for lodging and M&IE for each
of the following towns:
a. Flagstaff, AZ
b. Palm Springs, CA
c. Denver, CO
4-38 Chapter 4
Business Income and Expenses, Part II
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.