Business and Hobby Income and Expenses

I received an email this evening from some friends who are trying to figure out TaxCut (H&R Block's software). One of them started a new business last year, so they have some business income, and now the software is asking them all sorts of questions about car expenses and hobby income. (By the way, the line-by-line IRS instructions for schedule C can be found here. You might find them helpful.)

So here goes, and I'm including some general information for all my readers:

Schedule C is a form you file with your tax return if you have your own business (assuming you haven't incorporated), if you did any contract work where you were paid in cash or given a check without any taxes taken out, or if you received a 1099-MISC from someone. It's important to know whether this income was from a hobby or not, because there's a big difference in how it shows up on your return.

Rule of thumb: if you're in it for the money and intend to do what you can to turn a profit, then it is business income. You report your income and expenses for that business on a Schedule C, and the net profit or loss shows up on line 12 of your 1040. If you have a loss, you can deduct that from your taxable income. If you have a profit, then you have to pay self-employment tax on the income in addition to income taxes. Warning: if you report a loss from business income more than two or three years in a row, you should talk to a tax accountant about your situation. If you never turn a profit, the IRS will get suspicious that maybe it's really a hobby, in which case you shouldn't get the extra deduction.

Hobby or "nonbusiness" income should be reported on line 21 of your 1040, and the expenses go on Schedule A with your itemized deductions, but you can only deduct as many expenses as your hobby income. This is because you can't deduct hobby losses like you can business losses. So to answer the original question in the email--if you are reporting hobby income, you can enter related expenses along with your itemized deductions (to the extent that they are more than 2% of your gross income, and not more than the income you are reporting). So no, in the original situation, it sounds like you don't have any qualifying hobby expenses because the hobbies don't generate income.

With regards to attributing expenses to hobbies or business, again, if something is a legitimate business expense, you can deduct it on schedule C. If it is a hobby-related expense, you can deduct it on schedule A. Unfortunately, this isn't a situation where you can pick and choose. Business expenses you deduct on Schedule C must be ordinary and necessary to your business. The computer, unless it is used exclusively for a business for which you are filling out a schedule C, is probably not a qualifying expense. And if it is, you'd most likely deduct the depreciation of the computer instead of the actual cost. I don't know much about your particular business, but I might recommend dedicating one computer to business use.

That said, if you are itemizing and you have expenses for your job (like mileage) that your employer doesn't reimburse you for, you might be able to deduct some of those expenses on schedule A. The IRS information on this deduction can be found here.

The other question was about car and truck expenses. The way it works is that if you use a personal vehicle for business, you have to figure out the percentage of the total usage that was for business--you do that by keeping a mileage log. Now you have a choice: (1) calculate all of your automobile expenses for the year and use the percentage you just calculated. (2) Multiply the business mileage by the fixed rate the IRS determines. I recommend you read this explanation, which has some information about switching between methods year to year. You should consider what method will be more advantageous in the long run, as well as what is best for just the current year. In addition, the mileage rate changes periodically, and it actually changed last summer, which is why 2008 tax software will ask you for Jan-Jun and July-Dec mileage separately.

If you are using the actual expenses method, then one of your expenses is depreciation. Your car depreciates from year to year regardless of whether you're using it for business; if you happen to use it for business in a given year, then you can deduct a percentage of depreciation as I explained above. So the number of years you've owned the car is only important in calculating total depreciation for the current year; it doesn't affect your car expenses in any other way.

I hope this helps. If you need any other clarification, just respond to this post. Thank you for sending me your questions! Let me know if you need anything else.