Taxpayers who are in business to make a profit can generally deduct related expenses on their tax returns. If the IRS doubts a profit motive exists, it may deem an activity to be a hobby with a limited ability to deduct costs. The burden to prove there's a profit motive is on the taxpayer.
In one recent case, the IRS found a "green" home construction partnership was engaged in for personal pleasure. But the owners, a married couple and their daughter, showed they did operate in a businesslike fashion, consistent with a profit motive. They possessed industry expertise, spent substantial time on the activity and succeeded in entering new markets. "The factors of this case support a conclusion that the partnership was engaged in a for-profit activity," the U.S. Tax Court stated. Therefore, there were no tax deficiencies and no penalties. (TC Memo 2022-17)
Employee or independent contractor? When courts must decide how workers are to be classified, they look at various factors. In one recent case, the U.S. Tax Court found that a provider of private duty at-home nursing services to children with special needs failed to classify 99 nurses as employees during 2016–2018. The factors considered included the:
Based on the court's conclusion, the company was held liable for federal employment taxes and other taxes and penalties. (TC Memo 2022-35)
U.S. businesses must generally follow strict rules in how they report income and expenses. One key rule is the "matching principle," which requires that income and related expenses be reported (matched) in the same period. Even when a business strictly adheres to "generally accepted accounting principles" (GAAP), the IRS might challenge it.
In one recent case, the IRS believed that the way a retirement continuing-care community treated deferred fees (upfront payments from residents) didn't properly reflect its income. The U.S. Tax Court rejected the IRS's finding. The court pointed out that when GAAP is followed consistently over time, a business "will ordinarily be regarded as clearly reflecting income." (TC Memo 2022-31)
An urgent care center didn't pay the employment taxes reported on its Forms 941, Employer's Quarterly Federal Tax Return, for two quarters. The U.S. Tax Court upheld the Trust Fund Recovery Penalty imposed personally on a part-time bookkeeper working at the center. He argued that as a part-time employee, he wasn't a "responsible person" for payroll taxes that weren't paid over to the IRS. The bookkeeper had no ownership interest in the business. He claimed that the IRS settlement officer acted arbitrarily in assessing the penalty against him because he wasn't a company owner and was one of many bookkeepers.
However, the court found that the bookkeeper held the company's power of attorney and "has been granted the status, duty, authority and power to direct the collecting, accounting, and paying of trust fund/employment taxes." He was also "responsible for opening/responding to all IRS correspondence and contacts," the court stated. For these and other reasons, the bookkeeper was found to be a responsible person liable for the penalty. (TC Memo 2022-13)
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