Five Things to Remember about Hobby Income and Expenses

From scrapbooking to glass blowing, many Americans enjoy hobbies that are also a source of income. A taxpayer must report income on their tax return even if it is made from a hobby.

However, the rules for how to report the income and expenses depend on whether the activity is a hobby or a business. There are special rules and limits for deductions taxpayers can claim for hobbies. Here are five things to consider:

  • Determine if the activity is a business or a hobby. If someone has a business, they operate the business to make a profit. In contrast, people engage in a hobby for sport or recreation, not to make a profit. Taxpayers should consider nine factors when determining whether their activity is a business or a hobby, and base their determination on all the facts and circumstances of their activity. For more about ‘not-for-profit’ rules, see Publication 535, Business Expenses.
  • Allowable hobby deductions. Taxpayers can usually deduct ordinary and necessary hobby expenses within certain limits:
    • Ordinary expense is common and accepted for the activity.
    • Necessary expense is appropriate for the activity.
  • Limits on hobby expenses.  Taxpayers can generally only deduct hobby expenses up to the amount of hobby income. If hobby expenses are more than its income, taxpayers have a loss from the activity. However, a hobby loss can’t be deducted from other income.
  • How to deduct hobby expenses.  Taxpayers must itemize deductions on their tax return to deduct hobby expenses. Expenses may fall into three types of deductions, and special rules apply to each type. See Publication 535 for the rules about how to claim them on Schedule A, Itemized Deductions.

Revenue officials admit ‘huge burden’ of business expense reviews, offer tips for responding

By Jennifer Wentz, November 13, 2017 at 3:00 AM

Officials from the state Department of Revenue are trying to help tax practitioners and small-business owners cope with an onslaught of tax notices sent out under a recent agency initiative applying greater scrutiny to business expenses.

The agency’s efforts to offer guidance include a webinar and question-and-answer session held last week with members of the Pennsylvania Institute of Certified Public Accountants.

During the presentation revenue officials offered clarification on the kinds of documents they will accept to verify expenses, as well as best practices for communicating with the department throughout the review process.

The webinar stemmed from a fairly new Department of Revenue initiative to scrutinize expenses that some self-employed people and sole proprietors claim on forms called Schedule Cs. Business owners deduct these expenses from their business income in order to reduce their tax burden.

The revenue department recently bought software that sorts through individual claims on a filer’s return and flags any expenses that exceed average costs in the filer’s industry.

The department started a pilot of the program in the 2015 tax year and put it into full force this past year. The reviews resulted in an avalanche of tax notices being sent to small business owners, who often did not understand how to respond and had trouble reaching revenue officials when they tried to seek help, according to some tax professionals.

Revenue officials, meanwhile, struggled to keep up with the reviews and subsequent questions when the software flagged significantly more returns than they had anticipated.

“We recognize this was a huge burden and not necessarily what we intended,” said John Kaschak, the revenue department’s deputy secretary of taxation, during last week’s webinar. “This sort of snowballed.”

Here are some of the questions revenue department officials answered during last week’s webinar:

What kinds of documents count as verification?

Questions about what counts as verification topped the list of concerns for many tax preparers trying to help their clients through reviews, which, some said, seemed to require wading through piles of receipts.

The revenue department does not need every receipt for every expense questioned in a review, officials said.

In most cases, the department will accept general ledgers, schedules, summaries, logs, canceled checks, bank statements and credit card statements – all information, officials contend, that tax practitioners would have needed access to in order to prepare the returns in the first place.

If the question is about a utility expense, business owners can, in most cases, send a few representative utility bills as verification, instead of an entire’s year’s worth.

What is the best way to correspond with the department if I have questions or want to send documents?

Sending information via mail, even certified mail, adds six to eight weeks to the review process – so don’t do that, revenue officials said.

Instead, the department would prefer practitioners send verification documents via fax or email. Contact information is available on the revenue department’s website.

Practitioners can still send responses via traditional mail – something they might choose to do if, for example, the documentation is too large for an email attachment – but their clients should know that any documents sent will not be returned.

Reviews take on average about three months to complete, revenue officials said. Anyone who sent responses to the department more than three months ago and has not yet heard a responses should resend the information or reach out, preferably via email, to find out the status of the review.

How can I help my clients reduce their chances of receiving a notice next year?

The revenue department plans to do a version of these same reviews in the next tax year. Practitioners who want to help their clients avoid going through the process can provide verification for expenses they feel might be questioned with the initial return. The department does not expect to flag any expenses filers already verified during this year’s reviews.

The department also has a tip sheet for filing Schedule Cs on its website.

Determining whether an expense might trigger a review in the future, though, will remain a guessing game. The state does not plan to release the numbers it uses to decide when an expense is suspiciously high.

Why is the department doing this?

These reviews are desk reviews, which look at individual line items as opposed to full returns, and are subject to different legal guidelines than full audits. The revenue department maintains it has a legal obligation under the state tax code to “make inquiries, determinations and assessments of all the taxes imposed,” and these desk reviews help them do that.

The state did not conduct these reviews in past years because it did not yet have access to the software it now uses to flag outlier expenses.

The state has yet to determine how much additional tax revenue these reviews will bring in.

Read more about the reviews here.

Four Things to Know about Taxes and Starting a Business

New business owners have tax-related things to do before launching their companies. has resources to help. Here are some items to consider before scheduling a ribbon-cutting event.

Choose a business structure

When starting a business, an owner must decide what type of entity it will be. This type determines which tax forms a business needs to file. Owners can learn about business structures at The most common forms of businesses are:

Determine business tax responsibilities 

The type of business someone operates determines what taxes they need to pay and how to pay them. There are the five general types of business taxes.

  • Income tax – All businesses except partnerships must file an annual income tax return. They must pay income tax as they earn or receive income during the year.
  • Estimated taxes – If the amount of income tax withheld from a taxpayer’s salary or pension is not enough, or if the taxpayer receives income such as interest, dividends, alimony, self-employment income, capital gains, prizes and awards, they may have to make estimated tax payments.
  • Self-employment tax – This is a Social Security and Medicare tax. It applies primarily to individuals who work for themselves.
  • Employment taxes – These are taxes an employer pays or sends to the IRS for its employees. These include unemployment tax, income tax withholding, Social Security, and Medicare taxes.
  • Excise tax – These taxes apply to businesses that:
    • Manufacture or sell certain products
    • Operate certain kinds of businesses
    • Use various kinds of equipment, facilities, or products
    • Receive payment for services

Choose a tax year accounting period

Businesses typically figure their taxable income based on a tax year of 12 consecutive months. A tax year is an annual accounting period for keeping records and reporting income and expenses. The options are:

  • Calendar year: Jan. 1 to Dec. 31.
  • Fiscal year:12 consecutive months ending on the last day of any month except December.

Set up recordkeeping processes

Being organized helps businesses owners be prepared for other tasks. Good recordkeeping helps a business monitor progress. It also helps prepare financial statements and tax returns. See for recordkeeping tips.

Tax notice avalanche hits small businesses

By Jennifer Wentz, October 27, 2017

An onslaught of tax notices hitting some of Pennsylvania’s smallest companies has business owners and tax professionals alike scratching their heads — and, in some cases, digging through massive piles of receipts.

The questions and paperwork are the result of a relatively new state initiative to place more scrutiny on Schedule C documents, the forms that self-employed people and sole proprietors fill out to report their businesses’ profits and losses. The Pennsylvania Department of Revenue has flagged about 46,000 personal income tax returns involving Schedule C forms over the past several months, or roughly 8 percent of such returns filed with the state.

These reviews have caused headaches, and sometimes substantial costs, for one-man and mom-and-pop shops as they struggle to figure out how to substantiate what they say are run-of-the-mill business expenses, according to tax practitioners and small business advocacy groups.

State officials have acknowledged issues with the reviews and say they have changed their procedures to make the process easier for business owners. Some tax professionals, though, remain skeptical.

What’s happening?

It usually starts with a one-page letter.

The document often asks for proof of some kind of item or items on a business owner’s Schedule C tax form. It’s not an audit — audits involve a much more thorough examination of a business’s finances and are subject to different legal requirements — but rather an inquiry into “a line item or two” on a return, according to the Pennsylvania Department of Revenue.

These kinds of inquiries, called desk reviews, only started popping up in mailboxes in significant numbers over the past several months, according to several tax practitioners. The reviews are the result of data analysis software the Pennsylvania Department of Revenue is using to sift through Schedule C forms and flag any reported expenses that seem to fall outside industry norms.

Full-time examiners from the department’s personal income tax division — which has about 100 employees — are conducting the examinations, which state officials say take about an hour each to complete.

The revenue department piloted this process in the 2015 tax year and fully implemented it in 2016. The intention is to help the state meet its legal requirement to “make inquiries, determinations and assessments of all the taxes imposed” under the state’s personal income tax laws, the department said in an emailed statement.

“This project is as much about compliance as it is about collection,” department officials wrote in August in response to questions from the Pennsylvania Society of Tax and Accounting Professionals. “This Schedule is not something that the Department has traditionally looked at because previously we did not have the necessary analytical tools. We now have them available.”

Department officials expect the reviews will bring in additional money for the state but have stopped short of saying they are the direct result of Pennsylvania’s ongoing budget woes, which include a more than $2 billion deficit, persistent revenue shortfalls and a recent credit-rating downgrade.

Officials do not yet have a projection for how much money the state could bring in from the inquiries.

The reviews are not specific to any one industry, nor are they limited to people asking the state for a refund. Of the 46,000 returns flagged for review as of August, about a quarter were returns that sought refunds, another quarter had balances due and the rest neither sought a refund nor had taxes due.

Delays and confused

Tax professionals and the business owners they represent have struggled to understand just how to respond to these requests, with what they say is little guidance from the state.

“There’s really an outcry in the profession right now,” said Sherry DeAgostino, executive director of the Pennsylvania Society for Tax and Accounting Professionals. “The primary thing is people don’t know what is being requested.”

DeAgnostino’s organization has received close to 400 emails from tax practitioners asking for help with these requests. The problem, she said, is that a business owner might list $30,000 in work expenses for a given year. Providing an itemized breakdown of every purchase that makes up that $30,000 can prove near impossible for some small business owners and sole proprietors.

DeAgnostino has heard from tax professionals who say they have had to copy upward of 1,000 receipts to meet the revenue department’s requests. One practitioner was unsure what to do because the client did not own a copier scanner. Several others reported having clients who chose to give up legitimate tax breaks rather than go through the behemoth task of figuring out what information would answer the department’s questions.

That task becomes even more intimidating when you consider the kinds of businesses that typically fill out Schedule C forms, said Warren Hudak, a leader from the National Federation of Independent Business and owner of Hudak & Company, a Cumberland County accounting firm.

“They’re truly small businesses, truly mom-and-pop, very small in size,” Hudak said. “The guy has an idea, and maybe he wants to sell things on Etsy … Or maybe Dad wants to take on some Uber work at night to pay for Christmas presents. Someone who’s doing the work on the side, maybe testing the waters.”

“It’s very easy to target Schedule Cs in terms of getting money. Oftentimes, their records are a mess.”

Officials from the Department of Revenue have since said they do not want businesses to send them actual receipts unless they have no other form of documentation. They would prefer they send general ledgers, schedules, summaries, canceled checks and bank statements — not by certified mail, as many have done, but by fax or email.

DeAgnostino wishes the department had been more clear from the beginning on how exactly it wanted them to respond to these requests. These answers were especially hard to come by in the early months of the review process, when tax professionals struggled to get through clogged phone lines at the department and clients sat in limbo waiting for responses about the status of their reviews.

State officials have acknowledged these issues, saying the data analytics it used to flag returns from the 2016 tax year sparked more reviews than they had anticipated. They have refined the criteria for 2017, in addition to extending the deadline for business owners to respond to a review notice from 15 to 30 days, increasing the amount of time between first and second notices and developing educational material like a planned webinar and a published Schedule C filing tip sheet.

They also met in August with DeAgnostino and other practitioners from the Society for Tax and Accounting Professionals, resulting in a seven-page question-and-answer document published on the trade group’s website.

These steps are a good start, DeAgnostino said, and some things have improved since that meeting in August. She still worries, though, that the department is unfairly denying business owners legitimate tax deductions, and that a sole proprietor would still likely lack the expertise to respond to the department’s request without help from a tax professional.

“We just feel like it’s almost a fishing expedition approach to tax collection,” she said. “It’s inconsistent and unorganized, and they don’t think about the effect that it has on the small business owner.”


Tax notice avalanche hits small businesses

10 Million Taxpayers Face an Estimated Tax Penalty Each Year; Act Now to Reduce or Avoid it for 2017; New Web Page Can Help

WASHINGTON — The Internal Revenue Service today reminded taxpayers assessed an estimated tax penalty for tax year 2016 that they still have time to take steps to reduce or eliminate the penalty for 2017 and future years.
To help raise awareness about the growing number of estimated tax penalties, the IRS has launched a new “Pay as You Go, So You Don’t Owe” web page. The page has tips and resources designed to help taxpayers, including those involved in the sharing economy, better understand tax withholding, making estimated tax payments and avoiding an unexpected penalty.
Each year, about 10 million taxpayers are assessed the estimated tax penalty. The average penalty was about $130 in 2015, but the IRS has seen the number of taxpayers assessed this penalty increase in recent years. The number jumped about 40 percent from 7.2 million in 2010 to 10 million in 2015.
Most of those affected taxpayers can easily reduce or, in some cases, eliminate the penalty by increasing their withholding or adjusting estimated tax payments for the rest of the year. With a little planning, taxpayers can avoid the penalty altogether.
By law, the estimated tax penalty usually applies when a taxpayer pays too little of their total tax during the year. The penalty is calculated based on the interest rate charged by the IRS on unpaid tax.
How to Avoid the Penalty
For most people, avoiding the penalty means ensuring that at least 90 percent of their total tax liability is paid in during the year, either through income-tax withholding or by making quarterly estimated tax payments. Keep in mind exceptions to the penalty and special rules apply to some groups of taxpayers, such as farmers, fishers, casualty and disaster victims, those who recently became disabled, recent retirees, those who base their payments on last year’s tax and those who receive income unevenly during the year. For details, see Form 2210 and its instructions.
Taxpayers may want to consider increasing their tax withholding in 2017, especially if they had a large balance due when they filed their 2016 return earlier this year. Employees can do this by filling out a new Form W-4 and giving it to their employer. Similarly, recipients of pensions and annuities can make this change by filling out Form W-4P and giving it to their payer.
In either case, taxpayers can typically increase their withholding by claiming fewer allowances on their withholding form. If that’s not enough, they can also ask employers or payers to withhold an additional flat dollar amount each pay period. For help determining the right amount to withhold, check out the Withholding Calculator on
Taxpayers who receive Social Security benefits, unemployment compensation and certain other government payments can also choose to have federal tax taken out by filling out Form W-4V and giving it to their payer. But some restrictions apply. See the form and its instructions for details.
For taxpayers whose income is normally not subject to withholding, starting or increasing withholding is not an option. Instead, they can avoid the estimated tax penalty by making quarterly estimated tax payments to the IRS. In general, this includes investment income —such as interest, dividends, rents, royalties and capital gains —alimony and self-employment income. Those involved in the sharing economy may also need to make these payments.
Tips to Make Estimated Tax Payments
Estimated tax payments are normally due on April 15, June 15, Sept. 15 and Jan. 15 of the following year. Any time one of these deadlines falls on a weekend or holiday, taxpayers have until the next business day to make the payment. Thus, the next estimated tax payment for the fourth quarter of 2017 is due Tuesday, Jan. 16, 2018.
The fastest and easiest way to make estimated tax payments is to do so electronically using IRS Direct Pay or the Treasury Department’s Electronic Federal Tax Payment System (EFTPS). For information on other payment options, visit Taxpayers may also use Form 1040-ES to figure these payments. IRS Publication 505, Tax Withholding and Estimated Tax, is a resource on withholding and estimated payments.

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