Tax and Financial News July
Why Some People Are Afraid of the Hobby Loss Rules
Many tax advisors are very cautious when it comes to claiming hobby losses – and some would argue overly so. This conservative view stems from the impression that the taxpayer usually loses when challenged by the IRS. While technically true that the odds aren’t in your favor of winning a challenge, the overall risk often works out in the taxpayer’s favor over the long run. Below we’ll look at why tax advisors should start from the assumption of taking the losses.
Always a Loser
Taxpayers usually lose hobby loss cases. Typically, the odds are around 3-to-1 in favor of the IRS. So, on the surface it seems like the smart bet is to assume you’ll lose, but there are reasons not to plan based on this fact. First, this statistic only represents cases that are decided by the court. Taxpayers are usually pretty stubborn and most cases are settled in much more favorable circumstances to the taxpayer.
Second, the “losers” are often winners in the long run.
Why Losers are Really Winners
When a taxpayer loses a hobby loss case, they usually face a deficiency and an accuracy penalty of 20 percent. The key issue here is how long before the loss is challenged?
Let’s take a pretend case as an example. Assume we have a taxpayer with tax losses of $60,000 per year, a 35 percent tax rate and they are audited for three years and lose. This results in a $63,000 deficiency ($60,000 x 35 percent x 3 years), plus an accuracy penalty of $12,600 (20 percent of the $63k). Had they not claimed the deduction, they would have paid the $63,000 in taxes anyway, so this isn’t really a loss; only the accuracy penalty is.
This doesn’t sound so great, does it? Why would someone take 3-to-1 odds in a scenario like this? Let’s think for a minute; what if the taxpayer had been taking the losses for 10 years? Those first seven years that were never audited allowed the taxpayer to take the deduction. In this case we have $21,000 x 7 years = $147,000 in deductions that the taxpayer would have missed if they played it conservatively. Next, our hypothetical taxpayer would still be up more than $134,000 over the long term ($147k, less the accuracy penalty).
This all of course assumes the taxpayer is sincere in his or her efforts to make money and is not playing the “audit lottery,” which is of course unethical.
Tax courts look to see if a taxpayer is genuinely and honestly engaged in the activity for profit. Objective honesty is the standard, and it doesn’t matter how slight the odds of turning a profit are. The IRS isn’t looking to judge the taxpayer’s business acumen, but their objective instead. You’ll need to truly be trying to make money with the activity or you’re doomed to lose.
In the end, if a taxpayer has an honest objective to make a profit through a hobby, claiming the losses is typically in their interest. While they are likely to lose if challenged, they are guaranteed to lose if they don’t take the losses themselves. Finally, even if they lose certain years under audit, they are likely to come out ahead in the long run. So, if you’re truly trying to make money in a venture that could be seen as a hobby, it might not pay to be conservative.
General Business News July
How to Define and Calculate a Break-Even Analysis
According to data from a U.S. Small Business Administration Office of Advocacy report from August 2018, businesses have varied longevity.
Nearly 80 percent (79.8 percent) of business startups in 2016 lasted until 2017. Between 2005 and 2017, the SBA mentions that 78.6 of new businesses lasted 12 months. Similarly, nearly 50 percent lasted at least five years.
While there are many reasons why a company goes out of business – one is profitability. Knowing when the business is breaking even and will start making a profit can be accomplished with a break-even analysis.
Defining a Break-Even Analysis
As the SBA explains, a Break-Even Analysis is a useful way to measure the level of sales necessary to determine how many products or the amount of services that must be sold in order to pay for fixed and variable costs, otherwise known as “breaking even.” It refers to the time at which cost and revenue reach an equilibrium.
In order to get the Break-Even Quantity (BEQ), as the SBA uses, businesses must take their fixed costs per month and divide this figure by what’s left over after subtracting the variable cost per unit from the price per unit – or the product’s selling price.
These types of costs can include things such as rent or lease payments, property taxes, insurance, interest payments or monthly machine rental costs.
In contrast to fixed costs, such as taxes or interest payments for the next month or year, business owners also must deal with variable costs. Utilities and raw material expenses are two examples of variable costs.
Looking at electricity costs, the amount and price of kilowatts used per month will vary based on the amount and length of usage of lights, climate control equipment, production runs and the rate of kilowatts from the supplier.
Looking at raw materials, such as oil or precious metals, these costs can decrease or increase frequently due to tariff or commodity fluctuations.
Sales Price Per Unit and Further Considerations
When it comes to how much an item is ultimately sold for, there are different considerations for different product sales. If a company is selling a product for $100 on the retail level, and the business’ fixed costs are $4,000 and there’s $50 in variable costs, the Break-Even Quantity can be calculated like this:
$4,000 / ($100 – $50) = $4,000 / ($50) = 80 products (to break even)
If those products are surfboards priced at $100 each, then sales of the 81st surfboard and onward would represent profits for the company. It’s also important to see how changing either fixed costs or variable costs can make a difference in the break-even point.
Reducing Fixed Costs
If a business owner refinances a loan to a lower, fixed interest rate, or reduces a salary for the next 12 months, the overall fixed costs will go down. Here’s an example with a lower fixed cost for the same scenario:
$3,500 / $50 = 70 products (to break even)
Reducing Variable Costs
If a business owner searches for another supplier, such as one that’s not subject to import tariff costs that get passed on to consumers, variable costs can be reduced for the same scenario. In this example, the variable cost is reduced to $45.
($100 – $45) = 55
$4,000 / $55 = 73 products (to break even)
While each business has its unique costs and industry conditions, a break-even analysis can help business owners determine future moves.
Financial Planning News July
Financial Tips for Recent College Graduates
Members of the college graduating class of 2017 owed an average of close to $30,000 each in student loan debt. Imagine starting out adult life with that kind of debt load?
The prevalence of this type of mounting debt for a 21- or 22-year-old is unprecedented in U.S. history – and all the more reason why young adults need sound financial advice. Financial advisors might not necessarily market to this demographic; instead, waiting until they’re older and have assets worth their while. However, if today’s young adults don’t get off on the right financial footing with regard to managing debt, saving, budgeting and investing for the future, there won’t be that many in need of financial advice once they hit middle-age.
The following are a few tidbits of advice to help recent college grads develop successful money management habits.
Interestingly, many college graduates know they are in over their heads and welcome financial advice; in fact, they’re hungry for it. A recent survey found that the No. 1 goal for 94 percent of Millennials is to become debt free. Unfortunately, tackling thousands of dollars in debt while earning an entry-level salary is a difficult task. The first rule of thumb is to be patient.
It takes time to pay off that much debt. The best advice is not to develop expensive habits, such as buying an expensive car, one with poor gas mileage or a make that is known for expensive repairs. Don’t get into the gourmet coffee habit. Bring your lunch to work. These are common habits among young adults with little discretionary income, but the hard part might be refraining from this type of spending once they start earning a higher salary.
Any wage increases or monetary windfalls should be directed to paying off debt and establishing an emergency savings fund to cover three to six months of living expenses – just in case they get laid off or encounter a large, unexpected expense.
Just as it takes time and patience to pay off a large debt, it also takes time and patience for invested money to compound. Once debts are paid off, extra income should be devoted to a regular, automated savings plan, such as a tax-deferred retirement plan with a company match.
Here’s an example of the reward:
- Madison starts investing $10,000 a year at age 25 for 15 years, for a grand total of $150,000. At age 40, she stops and never returns to that investment habit.
- Aidan starts investing $10,000 a year at age 35 and continues that habit for 30 years – twice as long as Madison. His total contribution also is twice that of Madison’s, at $300,000.
By age 65, Aidan’s investment grows to $790,582. While Madison invested only half as much as Aidan, by age 65 her investment grows to $998,975 – $208,392 more than him (assuming a 6 percent average annual return). That’s what the power of compound interest can do for a new college graduate who starts saving young.
Compound interest works both ways, so it’s important that young adults don’t miss or make late payments on student loans or other debt. Such bad habits lead to negative information being reported on their credit report, resulting in a low credit score that can cause them to be turned down for loans or charged higher interest rates. It can even mean losing out on a job opportunity, as some employers check out candidate credit scores.
Above all else, young college graduates need to make debt payments on time, build a credit history and protect their credit score.
Ideally, no matter how large debt payments are or how little a new college grad earns, a young adult should get in the habit of saving the same amount of money each month. Even if it’s just $20 a paycheck; it’s not the amount that matters – it’s the habit.
The best way to accomplish this is to live below your means. When you get a salary increase, increase your monthly savings amount. The easiest way to entrench a savings habit is to “keep living like you’re still a college student.”