The Internal Revenue Service is looking closer this year at second businesses to weed out those taxpayers who actually are more involved in a hobby than a business.
Tax preparers were sent this warning from the IRS over the e-mail system, said Shawn George, community specialist with the IRS Pacific-Northwest district, based in Seattle. This district includes Hawaii.
The IRS said that there has been a "significant increase" in the number of Schedule C (profit and loss from a business) filings "which appear to be incorrectly filed."
"Of the 2.2 million Schedule C returns filed in 1995 at the Fresno Service Center (in California), over one-half million had losses less than $10,000 and low dollar gross receipts," the IRS said.
Based on a three-year trend, more than 90,000 taxpayers consistently filed returns in this manner, the IRS said.
The IRS considers a number of factors to determine whether an activity is for-profit and therefore qualified for a Schedule C filing.
These include: whether the time and effort you put into the activity indicate you intend to make it profitable; whether you are depending on income from the activity for your livelihood; whether your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business); whether you change your methods of operation in an attempt to improve your profitability; whether you were successful in making a profit in similar activities in the past; whether the activity makes a profit in some years, and how much profit it makes; and whether you can expect to make a future profit from the appreciation of the assets used in the activity.
According to the IRS, the agency looks at the overall situation so no one factor is critical in making the decision on who qualifies.
But based on examinations of more than 1,650 returns by IRS district offices, 78 percent resulted in the elimination of, or a change to, Schedule C, the IRS said.
The examination concluded:
Many activities were deemed not to be a trade or business, whose primary purpose is for income or profit.
Many taxpayers were not involved in the activity with continuity and regularity.
Many taxpayers were incorrectly categorizing schedule A "miscellaneous itemized deductions" as schedule C "trade or business expenses."
In January and February, the IRS sent letters to taxpayers who filed returns with Schedule C in the tax years 1992, 1993, and 1994. Taxpayers were asked to review their Schedule C submittals.
"If it is determined that they were not in a true trade or business, they may need to file an amended return removing the schedule C," the IRS said.
George said other "red flag" business expenses, which have been watched closely for many years, are the office in the home, and meals and entertainment.
For example, if you use your own automobile also for business purposes, you should record your total annual mileage as well as the number of miles driven for business purposes.
When you get in the habit of record keeping, she said, you will spend less time and effort maintaining those records. And you will find that adequate records made in a timely manner help ensure you pay the lowest possible tax.
Besides Schedule C mistakes, George said other common mistakes include: not signing the tax return, forgetting to attach the W-2 forms, not including the Social Security number, and math errors.
These errors can be expensive. For example, Sai said, the IRS can reduce your refund or increase your balance due if an incorrect Social Security number appears on your tax form.
The IRS will check all Social Security numbers on a return against a database at the Social Security Administration. In the event of a mismatch, the IRS may reduce this year's refund -- even if the Social Security number has been successfully used in the past.
If the IRS contacts you about an incorrect Social Security number on your return, you have just 60 days to get the problem resolved, Sai said.
One last note: If you discover that you missed some valuable deductions or you made a mistake on a prior year's return, you may be able to file an amended return.
Generally, an amended return may be filed within three years from the date you filed the original return, according to Sai.
