- 1 Why Reporting Extra Income Doesn’t Mean Paying Extra Taxes
- 2 hobby income taxes
- 3 FTB 3730 – Online Buying or Selling – Know Your Tax Obligation
- 4 How to Tax the Sale of Art as an Investment or a Collectible
Why Reporting Extra Income Doesn’t Mean Paying Extra Taxes
Maybe you’ve carried a Notary Public license in your pocket for three years. You’ve learned about a lucrative opportunity to make money as a Notary Signing Agent. This is a great opportunity because you can make your own hours which means it doesn’t have to interfere with your regular job. You take a class or two to learn the basics, purchase business cards and send letters to local lenders. Before too long your cell phone is ringing off the hook with calls for your services. By the end of the year you’ve racked up well over $8000.00 dollars in your new venture. But what is that $8000.00 dollars going to do to your overall tax liability? Is Uncle Sam going to eat you up?
Poor Uncle Sam, he’s really been given a bad rap. He’s not really so bad. Yes, it’s true. The government loves for you to make money; the more money you make the more potential tax to extract from you. But, the government also realizes that it costs money to make money. If you’ve made extra money through your hobby or a side job during the year you needn’t be afraid to declare it on your income tax return. It’s possible that you may be able to have your cake and eat it tooÃ¢Â?Â¦well, at least a slice.
Okay, you’ve made income from your hobby, whether it is tie-dyed tee shirts, rare stamp collecting or baking cartoon-character cookies. What are you going to do at income tax time? The general rule is that all income is subject to tax. The IRS defines income as financial gain derived from work or labor. Income may be earned or unearned; earned income comes from services performed while examples of unearned income may be royalties from artistic works or rental income. When you make income the government taxes you by a percentage based on the amount of your income, and other factors. There are personal and dependency exemptions which decrease tax liability and deductions either standard or itemized which further lower taxes owed. The assumption made by most tax-payers is that if you increase your income through hobbies or self-employment you will enter a higher tax bracket and owe more taxes. This is not necessarily so; actually you may break even, and in some cases, owe less tax.
How does this work? First and foremost learn to be an excellent, diligent record-keeper. Keep every receipt and invoice for all purchases. Do you drive a car? Keep a record of your daily gas mileage. Hobby expenses are deductible up to the amount of hobby income reported on the tax return. Hobby income is entered on line 21 of IRS Form 1040; the category is Other Income. But this income may be offset by your expenses. Your hobby expenses are deducted on Form 1040 Schedule A on line 22. If you are the tee shirt maker, what does all this mean for you? Maybe you originally purchased 10 tee shirts for three dollars a piece for your own use. You paid money for all the accessories needed for dying the shirts. There was the dye, urea, gloves, rubber bands, squeeze bottles, pre-wash, instruction manuals, etc. It doesn’t matter that these items were originally purchased for your own use. Once you sold the first eight shirts all of the above expenses became a potential tax deduction since they were necessary items for the sale. Did you drive to the mall to obtain the supplies? Your mileage is a tax deduction? The mileage allowance changes from year to year; for the last four months of 2005 the rate is 48.5 cents per mile. This is an increase from 40.5 cents for the first eight months. (This is due to increased oil prices.) Did you use your washing machine to pre-wash the shirts? The depreciation on your washing machine and your electricity are tax deductible. And what about those phone calls you made to your potential customers about the colors they wanted and the size of the shirts? Keeping records of all of these items may seem a major nuisance but may reap huge benefits at tax time. A good accountant or tax preparer will assist you in prorating things like electricity, telephone usage, heating and other home utilities that you use in your hobby. When all is said and done your original income from the sale of your tee shirts may be greatly offset by properly calculating all of the expenses incurred to make them. Good record keeping is the key.
If the call for your tee shirts is so great, you may decide that you want to take it to a higher level. Maybe you should begin a tie-dying business out of your home. Or maybe you want to make that Notary commission that has been languishing in your pocket for years work for you. The line between hobby and self-employment is sometimes thin. The IRS basically looks at the intent. If your intention is profit, it is considered self-employment. Self-Employed individuals must file a Schedule C (Sole Proprietorship) for each business at the end of the year. If you are the Notary Public looking to make big bucks as a signing agent, you are considered an independent contractor, and thus self-employed. The tools of your trade are all sources of tax deductions. For instance, signing agents must carry Errors and Omissions Insurance in all states and Notary bonds in some. The costs of these items are deductions. Your cell phone is your life-line; this is how potential lenders and agents will contact you on a daily basis. Thus the purchase and usage of your cell phone is a tax write-off. Did you take a class to learn to become a signing agent? The cost of your signing agent class is a deduction. You will need journals, notary stamps, certificates, pens, paper and log books. All of these office supplies are deductions. Your depreciable items will be your laser printer and fax machine. You may need an overnight courier account. A successful agent will advertise; business cards, resume letters and flyers may be deducted. Whatever your side job or self-employment may be will determine the types of expenses you will incur to perform your job successfully. Special clothing, automobiles, home office supplies and accountant fees are just a few.
How your extra income will affect your tax liability will, of course, depend on how much extra money you’ve made. If you’ve increased your income by $25,000 your liability will be potentially greater than the person who made $525.00. Keeping an accurate track of your expenses and costs to use as deductions can only help you, no matter which category you are in. The tax laws that govern sole proprietors and the self-employed differ from those governing the hobbyist. The individual’s intent is the starting point but the government wants those who called their services a business to show a profit. Self-employment must show a profit in three out of five years to be accepted as a viable business by the IRS. Self-employed individuals may actually show a loss on their tax returns so that when that income is reported on line 12 of Form 1040 it may have a negative value. The hobbyist may only make deductions to the extent of the hobby income. Your tax preparer or accountant is the place to start with questions on these issues; Uncle Sam also has many books and periodicals to help with these tax matters. It is always best to go ahead and declare your extra income; if the IRS finds out about it anyway, you may incur penalties for paying insufficient tax in addition to the extra tax you may owe. Keeping good records of your expenses may make gaining extra income a true “extra.”
hobby income taxes
Taxes for Writers
T his article is written to do more than just give you a working knowledge of how to cope with your taxes. That basic information of how to file a sole proprietor (that’s how most writers are treated, being self-employed individuals) or partnership or corporate return is covered in great detail in a free publication printed by the IRS, the Tax Guide for a Small Business. This essay is designed to deal with the specific provisions written into the law that affect us. Recognizing that not everyone is into reading tax codes on a daily basis, let me explain first just what the law is and where it comes from.
The Internal Revenue Code is the actual law, which is written by Congress, those folks that were elected. They pass different Acts which may change or modify existing Code sections and also write Committee Reports, which, while not the actual law itself, are often useful in getting a perspective on what Congress’ actual intent is.
The Regulations are direct applications of the law and are written by the Internal Revenue Service. Generally, IRS writes proposed or temporary regulations, invites comment on them when they are published in the Internal Revenue Bulletin (a sort of weekly reader of tax law) and later issues final regulations. Both the Code and the Regs are reliable sources of exact information.
However, if there’s one thing certain about the American taxpayer, it’s that someone, somewhere, will come up with a question not specifically addressed in the Codes or the Regs. Further tax advice and information may come from IRS-issued Revenue Rulings or Revenue Procedures, or even from court cases or private letter rulings. But be aware that these establish precedent extremely specific to a particular case. A further point with the court cases is that IRS has the option to disagree with a court case (it’s called "non-acquiescence9quot;) which means that while bound to follow the court’s ruling in the case involved, the IRS will not agree to apply this as a precedent in other cases.
If you’d like to see the actual code section or court cases, a law library is the best place to go for copies. Copies may also be requested by mail from the following address, but they will charge you a copying fee. That address is:
U.S.Government Printing Office
Washington, D.C. 20402-9371
An excellent free resource is the IRS Publications. I will refer to them frequently, as they are free for the asking by calling the IRS toll-free hotline in your area, and take about two weeks by mail when requested.
Rules That Apply To Authors, An Historical Perspective
That particular legislation that creates the tax laws we are bound to has been active where authors (and artists and film makers as well) are concerned. It isn’t difficult to get tax advice regarding simple items such as what form to use and what records to keep. What is a lot harder to find is information about the particular legislation aimed directly at this industry. The law is easier to understand if you trace back the prior rules first.
Back in 1976, Congress enacted code section 280, adding it to the IRS Code in 1954. This provision stated that production costs of "a film, sound recording, book, or similar property" would be prorated over "the period during which the taxpayer reasonably may be expected to receive all of the income he will receive from any such film, sound recording, book, or similar property"
The practical application of this meant that if you wrote a book, you needed to capitalize your expenses, which means you saved them up, accumulated them until such time as you actually made money from the sale of your book. Once you started receiving income, you then amortized your expenses, which means you then wrote them off proportionally to your income. The current-year income, divided by your total income, times the total cost, equaled your deduction. This wasn’t such a bad way to go, when you wrote a book and collected royalties. And if you were someone who wrote short stories, articles, or essays for magazines, receiving one-time payments like first North American Serial Rights (NASR), this really didn’t affect you, since it was specific to books. A later court case, A.T. Hadley, established further that authors were not the intended targets of this legislation, as it was targeted more to curb tax shelter activities. This weakened the IRS case for a truly stringent application of this provision. Summarized, this was how a basic accounting principle, the matching principle, was applied. The concept is a simple one: make the expenses match up to the income. Remember this idea – we’ll se a lot more of it.
The Tax Reform Act of 1986 (TRA ’86) repealed section 280 and wrote a new code section into the new Internal Revenue Code of 1986 (which replaced the Code of 1954). The uniform capitalization rules (unicap) were in code section 263A, and were an attempt to apply the matching principle more stringently than before. Where previously you could use a standard formula based on total income to amortize expenses of books, and if you were an ongoing business you were able to write off expenses as incurred for short items, now unicap required you to establish how long you could expect to receive income from every manuscript, and to specifically match the expenses to the income from each item. Since it’s nearly impossible to figure how long a particular book will remain in print, or how many times a short story will reprint, this was impractical. IRS responded to the outcry of the creative industry by issuing an elective ruling, contained in IRS Notice 88-62, called the "safe harbor rules." Simply put, the rules allowed you to capitalize your costs and write off 50% in the first year and 25% in the second and third year. This was elective, which meant you could choose to use it, or attempt to satisfy unicap instead. Not surprisingly, many people elected to go for the safe harbor rules. Although issued in June of 1988, it was retroactive to 1986, allowing authors to amend previous tax returns and use the safe harbor. Many did.
Then Congress reacted to this scenario by repealing unicap for authors, meaning that they struck down the law, made it as if it had never existed in the first place provided that you were an individual. The repeal did not (and still doesn’t) apply to partnerships and corporations. A noteworthy angle of this is that you do not need a written contract to create a partnership. By definition, if you have two or more individuals each contributing to an enterprise and expecting to share equally in the profits, you have a partnership. (See IRS Publication 54I, Partnerships.) Collaboration will often fit that definition, and if you’ve incorporated, then you are still bound by the rules for applying unicap. But where section 263A was repealed for individuals, the safe harbor rules were not repealed at all. This means that you may still, even if you are a partnership or corporation, choose to apply the safe harbor and write off your expenses over a three-year period, beginning with the year that the expenses are incurred, rather than waiting for income to be received.
The alternative to using the safe harbor therefore depends on what you are. For individuals, the unicap provision of the law was repealed. This means that where you may choose to utilize the safe harbor, you don’t have to. Since the repeal of unicap and the prior repeal of Section 280, there is at this time no provision in the law that treats individual writers differently than any other business activity. In other words, if you are an ongoing sole proprietorship incurring ordinary and necessary expenses relating to doing business during your tax year, you may simply write off your expenses in the year incurred exactly like any other small business. But don’t be surprised if new legislation comes up in the future to change this. Keeping in mind how active law makers have been in this area, the old law is till something we all need to understand in order to make informed choices such as: Do you really want to incorporate? Or collaborate? Or buy that new word processor this year?
Now that we’ve become current on the specific provisions directed at writers, artists, and film makers, let’s move on to the more general topic of how to do a tax return for an author. We will use an individual whose business would be a sole proprietorship, as our example. (I specialize in individual returns).
What Forms to Use
Some people write for a living. Some write as a sideline. There are some differences in how taxes are filed for businesses compared to hobbies, so the first thing you need to establish for yourself is whether you are involved in this as a trade. Businesses have distinct characteristics, e.g. a profit motive. A tax court case in 1965, C. Lamont, disallowed losses claimed where the individual had pursued the activity of writing, teaching and lecturing because of an interest in literature, rather than a desire to make profits. "Art for art’s sake" simply doesn’t work as a business, but would be more in the nature of a hobby.
A key point here is the losses from hobbies are not allowed. When you receive income from a hobby, you must include the gross income (whatever you got, without deducting any expenses against it) on "other income" line of your tax return. (On 1994 forms, which are used to explain this, as they’re the latest in print as I write, this would be line 21 of Form 1040. All further references given will be to 1994 forms as examples.) The expenses relating to this income may only be taken if you itemize deductions, in which case they are taken as miscellaneous deductions subject to the 2 percent limit. This means your hobby deductions, which may not exceed the amount of your hobby gross income, are taken on line 20 of the Form 1040 Schedule A, and they plus your other miscellaneous deductions will not produce a tax benefit for you unless the total exceeds 2 percent of your adjusted gross income, which is the figure on line 32 of the 1040 form. In other words, hobby deductions are sharply curtailed and never produce a loss.
On the other hand, if you have a profit motive (defined as a reasonable expectation of realizing a profit, which generally shoots down vanity presses), you still may not actually have active conduct of a trade or business. The amount of time you spend in pursuing this business activity is a factor. If you spend as much as 500 hours annual (this is not the only test for establishing a lack of passivity – see the instruction to Schedule C, line 1 for discussion, or order IRS Publication 925, Passive Activity and At-Risk Rules, from the IRS toll-free hotline in your area.) This is important since passive activities also have limitations on losses, and require a different form than an active business. For example, if you have a passive activity that generates royalty income, this income would not be subject to the self-employment tax, explained next.
Let’s discuss royalties for a moment. One of the most common mistakes I see on the tax returns for authors is a tendency to try and separate out he royalty income and put it into Schedule E, Rents and Royalties, instead. This is appropriate if you’re an owner of say, oil royalties, or if you’ve perhaps inherited the right to receive royalties from an estate. It is not appropriate if you are actually in the business of being a writer. Being in the actual business means you spend a certain amount of time and effort carrying on a business. Since it’s a business and not a passive activity, it isn’t subject to the limitations on passive losses. But the other side of the same coin is that the royalties become part of the gross income of your business, and are added in with whatever other income (e.g., first NASR, advances) on your Schedule C, Profit or Loss from Business, instead. Being part of your gross income from a trade or business, they are indeed subject to self-employment tax (a form of Social Security and Medicare taxes). Before you could avoid paying self-employment tax on this, you would have to be able to show that you are not in the trade or business of writing, which means that your expenses against writing income would not be deductible directly against your income, as with the Schedule C. Instead, you’d be putting yourself in the position of treating this as a hobby. If writing is simply a hobby, then your gross income from it would be included on your Form 1040, but your expenses could not produce a loss. If you continually produce income from such an activity over a significant period of time, it’s likely that an auditor might question as to whether this is actually a hobby or actually a business. If this activity is a trade or business, then pay self-employment tax on your income from it.
An actual business, a sole proprietorship, involves filing a Schedule C for your starting point. The Schedule C, Profit or Loss from Business, is where you include your gross income and write off your ordinary and necessary expenses. This means you’ll be able to write off your expenses without having to itemize deductions.
Let’s look a moment at gross income. When you’re in the business of being a writer, that means that your gross income will include such items as first NASR, royalties and royalty advances. A 1961 court case, Holbrook, established that royalty advances were considered fully taxable, despite the contention by the taxpayer that he might have to give them back and therefore shouldn’t be taxed until the advances was paid off by the book royalties. The U.S. Tax Court disagreed, stating that royalty was taxable when received. On the other hand, if you were in the situation where you properly included a royalty in your income and then had to give it back, you could then take a deduction for the repayment. The deduction is taken on the same form as you previously included the income on, e.g., the Schedule C.
A note about expenses, and particularly word processors. There’s a common tendency to think when you buy an asset, you can write off the expense that same year, and most of the time it’s true. But remember the matching principle – if you buy a computer that you’re going to use for maybe five or ten years, you wont’ generally be able to write it all off in one year. When you have a tangible asset with a useful life over a year that’s used to produce income, that’s a depreciable asset. This means that you’ll use Form 4562, Depreciation and Amortization Schedule, to write it off over a standard period. In many cases, you can make an election, a choice, to write off up to $17,500 worth of otherwise depreciable property in a single year, but it has to be the same year that you bought it and started using it in your trade. It’s called the section 179 deduction and has limits deriving from how much income you made and how much you spent on business assets. The whole (and rather complex) information on this is printed in two separate publications, number 534, Depreciation, and number 946, How to Begin Depreciating Your Property. Note that a computer used in your home is a "listed property", which has more restrictive rules than most.
The bottom line on our Schedule C will be your net income, and that goes in two places – it carries over to line 12 of the 1040 form, where it will add to your other income (such as wages or interest) and be figured in for your federal income tax, and that net income also carries over onto line 2 of the Schedule SE, Self-Employment Tax. Self-Employment Tax is actually your Social Security and Medicare tax, and if you made a net income of over $433, you must pay it. This is the tax that most beginning sole proprietors tend to overlook. Unlike income tax, there is no standard deduction and exemptions you can take against it, and the tax is 15.3 percent of 92.35 percent of your net from the Schedule C, except that if you make over $61,200 (1995 figures) you’ll hit a limit where the greater part of it stops then. See IRS Publication 533, Self-Employment Tax, for more information.
The reason I’m bringing this up is that the tax law system has been on a pay-as-you-go basis since July 1, 1943. The key here is that if you don’t pay enough of your tax as you go during the year, you can be hit with a penalty. The vehicle for paying as you go, yourself, is Form 1040ES, Declaration of Estimated Tax. If you’re going to owe as much as $500 when you file your tax return, including the self-employment tax, then you should look into estimated taxes. The minimum required payment to avoid penalty is 90 percent of your current year taxes or 100 percent of the last year’s taxes, but if you had a gross income over $150,000 (or $75,000 if you were married filing separately) in the previous year, you may not be able to use that 100 percent of prior year option. The IRS publishes a free booklet, Publication 505, Tax Withholding and Estimated Taxes, with detailed information and filled-in examples, available at the toll-free hotline.
The best overall publication for a new business is IRS Publication 334, Tax Guide for a Small Business. It’s a large, free reference. For example, Chapter 38 contains a comprehensive example of the tax return for a sole proprietorship, and the next three chapters illustrate tax returns for partnerships, corporations and S corporations. It’s also indexed, so that when you have a specific question regarding a subject, such as start-up expenses, or how to depreciate equipment, you can find it in the index, read that page listed, and at a bare minimum you’ll get a handle on the right question to ask. Calling the hotline to ask for it, you might also want to ask if any of the Small Business Workshops given by the IRS are scheduled to be presented in your area. The reason I haven’t gotten further into how you’ll do your tax return and take your ordinary and necessary expenses in more detail is that the publication does a better job than I could given the space considerations here. Other publications you might want to order are:
Pub. 463, Travel and Entertainment
Pub. 542, Corporations
Pub. 552, Recordkeeping
Pub. 587, Business Use of Your Home
Pub. 917, Business Use of a Vehicle
Pub. 910, Guide to Information Publications
Here’s a final note that effects only those of us successful enough to sell to other countries and collect foreign royalties. Frequently, the foreign country will send you a request for certification that you file a U.S. tax return. It’s because there are tax treaties between countries and, if the IRS property certifies that you file a U.S. tax return, they won’t withhold as much foreign tax from their payments to you.
In lieu of using a foreign certification form for this purpose, you may request that the IRS issue a Form 6166, Certification of Filing a Tax Return, by contacting:
Internal Revenue Service
Philadelphia Service Center
Philadelphia, PA 19114-0447
Form 6166 is not accepted in Italy, however, so you will have to obtain the Italian version of the form and send it to the Philadelphia Service Center for certification. For further information, Publication 686, Certification for Reduced Tax Rates in Tax Treaty Country, explains the process succinctly.
© 1993, 1996 Cyn Mason
Reprinted with Author’s Permission *
*This article was handed out as part of a presentation at a recent science fiction convention. The Author told the audience it was OK to reprint this. It is presumed that this includes the web as well. If this is incorrect, this document will be removed immediately.
FTB 3730 – Online Buying or Selling – Know Your Tax Obligation
Be informed about Internet sales and online auctions. The Internet Tax Freedom Act prohibits the taxing of access to the Internet. The Act does not apply to tax on income from online sales or sales or use tax on purchases made online. Some individuals mistakenly think that this law exempts income from Internet sales and online auctions from income tax, and that buyers do not have to pay use taxes on their purchases.
If you are an online auction seller or buyer, you may have tax responsibilities.
California residents are taxed on all income, regardless of source, within and outside of the U.S. This includes income passed-through from limited liability companies (LLCs) formed in other states. California nonresidents are only taxed on income from California sources, e.g., gain from sale of property in California, or wages earned in California.
Part-year residents are taxed on all income received while a California resident, and income from California sources while a nonresident. Several factors are involved in determining a change in residency status.
- FTB 1031 – Guidelines for Determining Resident Status
- 540 Instructions – Instructions for Form 540/540, California Resident Income Tax Return
- Form 540NR – Nonresident or Part-Year Resident
- FTB 1032 – Tax Information for Military Personnel
- FTB 1123 – Forms of Ownership
- FTB 689 – Read the Fine Print: Forming A Business Entity Outside of California
Earning money by selling items on the Internet affects a growing number of individuals and businesses. If you occasionally sell items through online auctions, you may be underreporting your income. Any time you earn income other than wages, you should evaluate whether the transaction is taxable. If you have an established business and you augment your sales with online auctions, remember to include the online auction sales in your business income. If your online transactions reach the level of a business activity (see the discussions on Hobby or Business that follows), you should determine whether it is appropriate to deduct ordinary and necessary business expenses. An ordinary expense is an expense that is common and accepted in your trade or business. A necessary expense is one that is appropriate for your business.
If you are in the business of selling items through auctions, you may also owe self-employment tax, employment tax, or excise tax.
- FTB 984 – Common Business Expenses for the Business Owner and Highlights of the Federal/State Differences
- FTB 1001 – Supplemental Guidelines to California Adjustments
- IRS Pub 334 – Tax Guide for Small Business (For Individuals Who Use Schedule C or C-EZ)
- IRS Pub 463 – Travel, Entertainment, Gift, and Car Expenses
- IRS Pub 525 – Taxable and Nontaxable Income
- IRS Pub 535 – Business Expenses
- IRS Pub 583 – Starting a Business and Keeping Records
- IRS Form 1040 – Self-Employment Tax
- IRS video on Business Income
Hobby or Business – Is your hobby really an activity engaged in for profit?
Generally, your activity is considered a business if it is carried on with the reasonable expectation of earning a profit.
If your activity is a hobby/not-for-profit activity, allowable deductions cannot exceed the gross receipts for the activity. See Internal Revenue Code Section 183, Activities Not Engaged in for Profit, for limits on deductions that can be claimed.
If you are not sure whether your activity is an activity engaged in for profit, reaching the level of a business activity, or a hobby, here are eight questions that will help you determine if your activity is a hobby or a business:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from the activity?
- If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
An activity is presumed carried on for profit if it makes a profit in at least three of the last five tax years, including the current year.
Deductions for hobby activities are claimed as itemized deductions on Schedule A, Form 1040. These deductions must be taken in the following order and only to the extent stated in each of the following three categories:
- Deductions you may claim for certain personal expenses, such as home mortgage interest and taxes, may be taken in full.
- Deductions that do not result in an adjustment to the basis of property, such as advertising, insurance premiums, and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
- Deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.
If you operate an online auction as a business, you may be entitled to deduct business expenses. In general, you may deduct ordinary and necessary expenses for conducting a trade or business or for the production of income. Trade or business activities and activities engaged in for the production of income are activities engaged in for profit. Good records help you monitor the progress of your business, prepare your financial statements, identify the sources of your receipts, keep track of deductible expenses, prepare your tax returns, and support items reported on your tax returns.
If you use a portion of your home for your online auction business, you may be able to take a home office deduction. In order to deduct expenses related to the business use of your home, you must carry on a “bona fide” business, as well as meet other specific requirements. Your deduction may be limited. To qualify to claim expenses for the business use of your home, you must meet both of the following tests:
- Use of the business part of your home must be:
- For your trade or business.
- The business part of your home must be one of the following:
- Your principal place of business.
- A place where you meet and deal with customers in the normal course of your trade or business.
- A separate structure you use in connection with your trade or business.
- IRS Pub 587 – Business Use of Your Home (Including Use by Day-Care Providers)
- IRS Form 8829 – Expenses for Business Use of Your Home
If your online auction sales are the equivalent of an occasional garage or yard sale, you generally do not have to report the sales. In a garage sale, you generally sell household items purchased over the years and used personally. If you paid more for the items than you sell them for, the sales are not reportable and any losses on personal use property are not deductible. If your online garage sale develops into a business and/or you have recurring sales and purchase items for resale with the intention of making a profit, you may have started an online auction business.
If you have online auction sales where the sales price is more than your cost or other basis, you usually will have a reportable gain. These gains may be business income or capital gains.
If you sell business assets or close your business you may have capital gains, ordinary gains, and depreciation recapture to report.
California residents are also required to pay a tax when they purchase tangible property that will be used, consumed, or stored in California. California law requires tax on in-state purchases, and also requires tax on items purchased out-of-state for use in California. Tax collected by the retailer here in California is called sales tax, and the retailer is responsible for reporting and paying the tax. When an out-of-state or online retailer doesn't collect the tax for an item delivered to California, the purchaser may owe "use tax," which is simply a tax on the use, storage, or consumption of personal property in California. Items that are exempt from sales tax are exempt from use tax as well. Use tax liabilities are often created by Internet or mail order purchases with out-of-state retailers not required to collect the tax. If you are purchasing from an online auction seller you may have a Use Tax responsibility. Be sure to review your receipts for Internet and other out-of-state purchases to determine if tax was charged. For more information, go to the California Board of Equalization website at www.boe.ca.gov. You can also call their Information Center at 800.400.7115.
- Pub 61 – Sales and Use Taxes: Exemptions and Exclusions
- Pub 105 – District Taxes and Delivered Sales
- Pub 110 – California Use Tax Basics
- Pub 123 – California Businesses: How to Identify California Use Tax Due
- FTB 988 – California Use Tax and Your Filing Requirements
Do I need to get a seller's permit to sell on online auction sites?
If you are a California resident and sell items on online auction sites regularly, you will most likely need a seller’s permit. A “retailer9rdquo; is defined in the law (section 6019 of the Sales and Use Tax Law) to mean, among other things, every individual or firm making more than two retail sales of tangible personal property during any 12-month period. Persons engaged in the business of making retail sales at auction of tangible personal property owned by such person or others are retailers, and are, therefore, required to hold sellers’ permits and pay tax on the gross receipts from such sales. A seller’s permit allows you to collect sales tax from California customers and report those amounts to the board. There is no charge for a seller’s permit, but security deposits are sometimes required.
As a California retailer, you are responsible for paying the correct amount of sales tax to the California State Board of Equalization for sales made to Californians unless the item or person is specifically exempt by law. You may be reimbursed by your customers for the amount of tax you owe on a sale. If you do not pay the correct amount, the additional tax plus applicable penalty and interest will be charged. For more information, go to the California Board of Equalization website at www.boe.ca.gov. You can also call their Information Center at 800.400.7115.
- Pub 107 – Do You Need a California Seller's Permit?
- Pub 73 – Your California Seller's Permit
- Pub 109 – Are Your Internet Sales Taxable?
- Pub 177 – Internet Auction Sales and Purchases
- Pub 100 – Shipping and Delivery Charges
- Pub 101 – Sales Delivered Outside California
- Regulation 1565 – Auctioneers
- California City and County Sales and Use Tax Rates
People who hold garage sales generally are not required to hold seller’s permits unless they hold more than two garage sales in a 12-month period or are required to hold a seller’s permit for being engaged in the business of selling merchandise, goods or items (tangible personal property).
Generally, if you make three or more sales in a 12-month period you are required to hold a seller’s permit. This applies even if your sales are made through Internet auction houses or websites that offer online classified advertisements (online advertisers). For more information, go to the California Board of Equalization website at www.boe.ca.gov. You can also call their Information Center at 800.400.7115.
- Pub 107 – Do You Need a California Seller's Permit?
- Pub 73 – Your California Seller's Permit
- Pub 109 – Are Your Internet Sales Taxable?
- Pub 177 – Internet Auction Sales and Purchases
- Regulation 1595 – Occasional Sales—Sale of A Business—Business Reorganization
- Regulation 1565 – Auctioneers
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How to Tax the Sale of Art as an Investment or a Collectible
The profits you earn from the sale of art is certainly taxable. If you aren't the artist, and the sales aren't related to your business, how much tax you'll owe from annual art sales depends on whether you purchased the pieces as an investment or as a casual collector, as the classification dictates whether you can deduct all related expenses or not. The difference in tax that an investor and a collector owes on art sales can sometimes be substantial.
A principal factor that distinguishes art investors from casual collectors is the motive to earn future profits from their collection of paintings, sculptures and other artwork. Generally, if your main goal is to profit when the collection appreciates in value, you may be more like an investor than a collector. Despite a collector's understanding that their art is likely to increase in value, a collector's main reason for purchasing art is because of his hobby interest -- which means it's a leisure activity rather than an investment. Note, however, that if you earned a profit in three of the most recent five tax years -- counting the current year -- the Internal Revenue Service presumes that you're an investor.
Regardless of whether the art is treated as an investment or hobby activity, all profits are treated as capital gains that are taxed at the same rates. Pieces of art you own for one year or less at the time of sale are taxed at ordinary income tax rates, which are the same progressive tax rates that apply to your other income, such as the wages you earn at your job. When you own the art longer than one year, the profit is a long-term capital gain. A net long-term gain from the sale of any collectible is taxed at the special rate of 28 percent.
Casual collectors are subject to the tax rules that govern “hobby income.” As a result, a limited number of expenses related to art sales are deductible on Schedule A, but only to the extent that they don't create an overall loss for the year from all art sales. You must take deductions in a specific order, too. In the context of rare art, this means you must deduct expenses that don't affect your basis in the collection, like insurance premiums, before depreciation deductions are allowable for those pieces of art that decrease in value after you purchase them.
Investors are permitted to deduct more of their related expenses, such as the cost of preserving art and advertising a sale, regardless of whether it results in an overall gain or loss. If your expenses as an investor exceed all gains for the year -- which is calculated as the sales price minus your original cost in most cases – you can use the loss to offset the taxable gain from other types of investment gains you have, which isn't the case with the casual investor. One drawback to treating your art as an investment is that your gains may be subject to the 3.8-percent net investment income tax in addition to capital gains taxes.
Michael Marz has worked in the financial sector since 2002, specializing in wealth and estate planning. After spending six years working for a large investment bank and an accounting firm, Marz is now self-employed as a consultant, focusing on complex estate and gift tax compliance and planning.