Gardening and Retailing Opportunities in Wayne County

1
Gardening and Retailing Opportunities in Wayne
County

• Federal Tax Considerations in Choice of Business
  Entity
• April 24, 2007

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Hobby vs. Business

• An initial consideration for tax purposes is
  whether the activity is a hobby or a business.
• Income received is taxable in either case, but
  deductions are limited in a hobby situation.

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Hobby Activity

• Hobby defined
• Activity not entered into for profit
• Personal pleasure is usually, but not
  necessarily, associated with activity
• Often it is difficult to determine if an activity
  is profit motivated or a hobby
• Treasury Regulations provide factors to consider
  in making this determination

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Treasury Regulation Factors

• Manner in which activity carried on.
• Expertise of taxpayer and advisors.
• Time and effort expended.
• Expectation that assets used will appreciate.
• Success in other activities.
• History of income and losses.
• Amount of occasional profits.
• Financial status of the taxpayer.
• Elements of personal pleasure or recreation.

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Presumptive Rule

• Presumptive rule of IRC 183
• If activity shows profit 3 out of 5 years (2 out
  of 7 years for horses), it is presumed that
  taxpayer has profit motive
• This is a rebuttable presumption, but shifts the
  burden of proof to IRS
• Otherwise, the taxpayer has the burden to prove a
  profit motive

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Tax Treatment of a Hobby Activity

• Income is taxable as other income.
• Expenses are only deductible to the extent of
  income from the activity (hobby losses are not
  deductible).
• Expenses are deductible as itemized deductions
• Treated as miscellaneous itemized deductions
  subject to the 2 of Adjusted Gross Income
  (AGI) limitation.
• Exception expenses that are deductible
  without regard to profit motive, such as
• Mortgage interest
• Property taxes

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Profit Activity

• If the activity is entered into for profit, the
  taxpayer can deduct expenses in excess of income
  from the activity as a business loss. Losses are
  deductible in arriving at AGI.
• At-risk and passive loss rules may apply.

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Business Entity

• Assuming that weve determined that our
  activity is a business, there are four basic
  choices for business entity.
• Sole proprietorship
• Partnership (General or Limited)
• Limited Liability Company
• Corporation (C or S)

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Sole Proprietorship

• Frequently used for a small business.
• Unlimited liability.
• Not a separate taxable entity.
• Income reported on owners tax return using
  Schedule C, C-EZ, or F.
• If operating under a name other than that of the
  owner, a Certificate of Assumed Name (DBA) should
  be filed with the county clerks office.

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General Partnership

• Unlimited liability for general partners.
• Separate entity, but does not pay income tax.
• Allocates partnership income to partners.
• Partners report partnership income on personal
  tax returns
• Files information return (Form 1065).
• A Certificate of Assumed Name (DBA) should be
  filed with the county clerks office.

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Limited Partnership

• Unlimited liability for at least one general
  partner.
• Limited liability for limited partners.
• Limited partners have no voice in management.
• A Certificate of Limited Partnership must be
  filed with the Michigan Department of Labor
  Economic Growth, Bureau of Commercial Services,
  Corporation Division.

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Limited Liability Company

• Allows the entity to avoid unlimited liability
• Allows a business to be treated as a sole
  proprietorship or partnership for tax purposes,
  avoiding the double taxation associated with C
  Corporations.
• Articles of Organization must be filed with the
  Michigan Department of Labor Economic Growth,
  Bureau of Commercial Services, Corporation
  Division.

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Check the Box Regulations

• Check-the-box Regulations
• Allows taxpayer to choose tax status of entity
  without regard to corporate or noncorporate
  characteristics by filing Form 8832.
• Entities with more than 1 owner (member) can
  elect to be classified as a partnership or a
  corporation.
• Entities with only 1 owner can elect to be
  classified as a sole proprietorship or as a
  corporation.

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Check the Box Regulations

• If no election is made, multi-owned entities
  treated as partnerships, single person businesses
  treated as sole proprietorships.
• Election is not available to
• Entities incorporated under state law, or
• Entities required to be corporations under
  federal law (e.g., certain publicly traded
  partnerships)

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Corporation (C Corporation)

• Separate tax-paying entity (unless S corporation
  election is filed).
• Reports income and expenses on Form 1120 (or
  Form 1120-A)
• Income is taxed at corporate level and again at
  owner level when distributed as a dividend.
• Articles of Incorporation must be filed with the
  Michigan Department of Labor Economic Growth,
  Bureau of Commercial Services, Corporation
  Division.

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S Corporation

• Organized as a corporation under state law. An
  election to be treated as an S Corporation is
  filed with the IRS.
• Separate entity but does not generally pay
  income taxes (with limited exceptions).
• Allocates entity income to shareholders.
• Shareholders report entity income on personal tax
  return
• Files information return (Form 1120S).

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Other Tax Considerations

• Assuming that a sole proprietorship is the choice
  for business entity, there are other tax issues
  to consider
• Self-Employment Tax
• Estimated Tax

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Self-Employment Tax

• Sole proprietors have to pay both the employees
  and the employers Social Security and Medicare
  taxes. This is computed on Schedule SE,
  Self-Employment Tax.

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Self-Employment Tax

• The basic calculation of self-employment tax is
• Net profit (line 3, Schedule C-EZ, line 31,
  Schedule C, line 36, Schedule F)
• Multiplied by .9235
• This total (if 400 or more) multiplied by 15.3
• Optional computation methods are available in
  certain situations.
• A deduction from AGI is allowed in the amount of
  one-half of the self-employment tax computed
  above.

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Estimated Tax

• If a taxpayer owes 1,000 or more not covered by
  withholding, an estimated tax penalty might
  apply.
• To avoid it, an annual payment equal to the
  smaller of the following amounts needs to be paid
  quarterly unless paid through withholding
• 90 of the tax on the current return
• 100 of the tax shown on the preceding years
  tax return (110 for certain higher income
  taxpayers)
• Note Withholding counts as ratably paid, no
  matter when the taxes are withheld.

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Other Issues To Consider(not included in todays
discussion)

• Business Plan
• Business Name
• Licenses and permits
• Sales tax
• Reporting of income and deductions
• Employees and related issues
• Record-keeping

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Resources

• www.Michigan.gov Guide to Starting a Business
  in Michigan from the Michigan Economic
  Development Corporation
• www.irs.gov Publications, tax forms, and
  instructions from the Internal Revenue Service

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Thank you for your participation in this
presentation!

• Marshall J. Hunt, CPA
• Director, Tax Assistance Program
• Accounting Aid Society
• 18145 Mack Avenue
• Detroit, MI 48224-1444
• 313-647-9620
• Email mjhunt_at_accountingaidsociety.org
• Website www.accountingaidsociety.org
• Accounting Aid Society is a partner
  agency of the United Way for Southeastern
  Michigan.