Tax and Business Alert - August 2002

Avoiding the Hobby Loss Trap

Classifying an activity as either a business or a hobby is critical for tax purposes since you cannot deduct losses from hobbies on your tax return.   Making this determination, however, is not always clear-cut. The IRS "backs-into" the definition of activities not engaged in for profit (i.e., hobbies) by including all activities other than those that qualify as business or investment activities. Thus, the facts and circumstances of each activity must be reviewed.

Many hobby loss issues center on the weekend farmer or rancher. However, the rules are applicable to any type of activity, and have frequently been applied to auto racing; horse (or dog) racing, breeding, or showing; cattle breeding; and acting, films, and filmmaking. In any case, your activity must be conducted with the actual and honest intent of making a profit to escape the hobby loss taint.

ESTABLISHING A PROFIT MOTIVE

The IRS considers many factors when determining if you are out to make a profit in an activity. These include the existence of a sound business approach, your expertise in the particular activity, how much time and effort you devote, and if there is a reasonable expectation that your business assets will appreciate in value. The IRS also looks at your activity's past financial performance, including the occurrence of profits and losses and their relative size, your degree of success with any previous businesses, whether you have substantial income from other sources, and the level of personal pleasure or recreation you received.

COMBINING ACTIVITIES TO AVOID HOBBY TREATMENT

Combining a questionable activity with a legitimate business may help you avoid hobby treatment. For example, the Tax Court allowed a Kentucky farmer who opened a public display garden and conservatory to aggregate the farming and garden activities for testing under the hobby loss rules because the activities had a close organizational and economic relationship. Conversely, the Tax Court rejected a dentist's claim that his dental practice and apple orchard should be treated as a single activity because the apples provided health benefits to his patients.

USING THE SAFE HARBOR RULE TO ELIMINATE UNCERTAINTY

A safe harbor test exists that, if met, causes a presumption that your activity is a for-profit endeavor. If the safe harbor is not met, you must establish a profit motive using the subjective factors previously discussed. To meet the safe harbor, your activity must generate a profit in at least three of five years (two of seven years for activities involving horse racing, breeding, or showing) ending with the tax year in question. If the safe harbor is met, the burden of proof for lack of a profit motive is shifted from you to the IRS. The IRS can still rebut the profit motive presumption by proving that the activity is not engaged in for profit. In most cases however, the IRS will not attempt to rebut the presumption unless there are extenuating circumstances.

IRS Tests Online Refund Tracking

The IRS is testing a new Internet-based service that will allow you to check the status of your tax refunds anytime from anywhere. The web application, expected to be fully operational for the 2003 filing season, represents a major step forward for IRS modernization.

The IRS recently moved the pilot project to the front page of its website (see "Where's My Refund?" at www.irs.gov) to test its ability to handle a large volume of users. If you file Form 1040, Form 1040A, or Form 1040EZ and are due a refund, you may use the application. The program will mark the first time taxpayers will be able to access their accounts directly through the Internet.

You can use the Internet to find out if your tax return has been processed and when your refund will be mailed or direct deposited. The application can also help you determine if there is a problem with your refund and if your check was returned to the IRS as undelivered. To use the program, you must know your Social Security number, your filing status (e.g., single, married filing jointly), and the amount of your refund.

The refund service has undergone extensive testing throughout its development, including a six-month, comprehensive security process to qualify for an IRS security certification. A security certification is required for any IRS computer system that deals with taxpayer information.                          

Timely Tax Tips

Tax Credit for Summer Day Camp Expenses.   If your son or daughter under age 13 attends a summer camp (and doesn't stay overnight), the cost may qualify for the child care credit. IRS-imposed requirements and limitations exist, but, if available, the credit can range from 20% to 30% of the camp's cost.

A New Above-the-line Deduction for Teachers and Educators.  Beginning in 2002, if you're a primary or secondary level teacher or educator, you can take an above-the-line deduction for up to $250 in out-of-pocket classroom expenses. Eligible items include books, supplies (other than non-athletic supplies for health or physical education courses), computer equipment (including related software and services), and other equipment and supplementary materials used in your classroom.

Tax-free Commuting and Parking Costs.  Employer provided qualified transportation fringe benefits are excludable from your income, up to certain limits.  These fringe benefits include (1) commuter transportation, (2) transit passes, and (3) qualified parking. For 2002, the combined value of commuter transportation and transit passes you can exclude from income is limited to $100 per month, while the amount of qualified parking you can exclude is limited to $185 per month.

Interesting Websites

Cases of identity theft are increasing so rapidly that the U. S. Congress is debating ways to provide more consumer protection in this area. To help you avoid identity theft and other forms of consumer fraud, the credit reporting companies have posted helpful information on their Websites. The Equifax site (www.equifax.com) covers various topics including a definition of identity theft, 10 ways to protect against it, the effects it has on the victim, how identity theft happens, and what consumers should do if they suspect their identity has been stolen. The site also includes information on how to obtain your credit information and how to improve your credit rating.

The Trans-Union Corporation website (www.transunion.com) lists 16 ways to avoid fraud involving your credit cards and bank accounts. Other informational websites include CSC Credit Services (www.csc.com) and Experian (www.experian.com).

Time to Try Exchange Traded Funds?

How much can DIAMONDS®, SPYDRs®, and Cubes help you with tax-efficient investing? The answer is, a great deal. These are acronyms for three of the most widely held Exchange Traded Funds (ETF’s). ETF’s represent your ownership in baskets of stocks that closely track the performance of specific market indices. ETF’s are designed to emulate broad market, international, or sector indices. DIAMONDs® (symbol DIA) represents the Dow Jones Industrial Average; SPYDRs® represents the Standard & Poor's 500 Composite Stock Price Index®; and Cubes (symbol QQQ) represents the NASDAQ 100-Index Tracking Stock.

Fund shares are exchange listed and trade throughout the day. You can purchase ETF shares through a broker and specify the price at which you are willing to trade using stop and limit orders. A typical mutual fund, on the other hand, is only priced for sale or purchase at the end of the trading day.

There are more than 100 listed ETF’s providing you a variety of market opportunities in the broad market, industry sector, fixed income, and international arenas. In addition to providing a core investment vehicle, ETF’s can be used for portfolio diversification, hedging, cash management, rebalancing, and tax loss strategies. The value of an ETF changes with market conditions, so you should review suitability characteristics the way you would with any other investment.

ETF’s ARE TAX EFFICIENT

You may have become aware of a detrimental aspect of mutual fund investing when you received your 2000 and 2001 mutual fund 1099s. Already disappointed with poor investment returns, many investors are finding a significant amount of taxable distributions received during the years, which makes things worse.

The problem is mutual fund managers, scrambling for cash to meet shareholder redemptions, sold securities with embedded capital gains. (Mutual fund managers usually only hold a small percentage of fund assets in cash.) These capital gains are passed through to you, the fund shareholder. That creates quite a dilemma-falling share prices and significant taxable distributions.

ETF shareholders fared considerably better from a tax standpoint in 2001. Generally, they didn't need to worry about shareholder redemptions because purchase and sale transactions do not take place at the portfolio level. ETF’s only adjust their portfolios when a stock leaves the index. Therefore, they rarely record capital gains. Individual investors sell their shares on a stock exchange eliminating the need for a fund administrator to sell shares to cover redemptions and therein create capital gains.

ETF’s ARE COST EFFECTIVE

ETF’s are "exchange-traded" so you do pay a brokerage commission with your purchase or sale. However, you do not pay a "load" similar to a traditional index mutual fund. In addition, ETF expense levels are usually less than those associated with a typical index mutual fund.

SOME ADDITIONAL CHARACTERISTICS

If you are a sophisticated investor, you can sell all ETF shares "short." Short selling is the sale of borrowed shares in anticipation of lower prices. After the short sale, identical shares are purchased to "cover" or replace the shares you initially sold. In addition, you can purchase ETF shares on margin subject to the same terms and conditions that apply to corporate stocks.

ETFs pay dividends equal to the fund's dividend income less the fees and expenses of the trust holding the portfolio. Dividends are paid to you quarterly in cash and cannot be reinvested. Please give us a call if you would like more information on ETF investments.         

FICA Refund Opportunity

Payments an employer makes to downsized workers have generally been subject to federal income tax withholding. However, a recent Court of Federal Claims decision brings the FICA treatment of such payments into question. The court concluded that payments made to downsized workers that qualify as supplemental unemployment benefits (SUBs) aren't wages and remuneration for services and, therefore, are not subject to FICA tax.

To qualify as SUBs, payments must be made from an employer's plan to employees because of their involuntary separation from employment due to a reduction in force, the discontinuance of a plant or operation, or other similar conditions. The Claims Court determined that amounts paid to employees laid off as a result of workforce reductions and payments made to workers who elected to receive them instead of layoff benefits were SUB payments. Such payments are not subject to FICA since these employees were involuntarily terminated and no longer working for the company. Alternatively, payments made to employees because their hours or rates-of-pay were reduced were not SUB payments and, therefore, were subject to FICA since the individuals were still company employees. Similarly, payments to workers who chose separation payments instead of remaining in their existing positions were not SUB payments exempt from FICA because these payments were made because of a voluntary separation.

If you've made SUB payments, you may want to consider filing for a refund of any FICA tax paid (and FICA tax withheld from affected employees) on those payments. Prior to filing for a refund, you must repay or reimburse the affected employees for their part of the overpayment or obtain written consent to obtain the refund on their behalf. Additionally, it may be necessary for you to file a Form W-2c (Corrected Wage and Tax Statement) to correct the employee's social security wage information. Be aware, however, that the IRS has said it will appeal the loss in court. Thus, until the case is decided, it will probably not allow your refund claim. As a result, you should consider filing protective claims for any tax period that is about to expire under the three-year statute of limitations. Otherwise, it may be best to sit tight and let the Court of Federal Claims case work its way through the appeal process before deciding whether to file a refund claim for more recent tax years.