Determining Legitimate Business Or Hobby For Taxation Purposes

Taxation The Limits Of Government New York

What Indicates an Intention to Profit from Business Activity?

Larry Lowry is employed with Greener Gardens Ltd and also does outside jobs as a gardener. He plays guitar and sings at the Sunday Market as a hobby, hence his earnings of $1,500 from this hobby are Tax Exempt earnings. His letting-out of two bedrooms of his three bedroom house is treated as Rental Income and Larry is entitled for claiming expenses associated with this let-out portions as deductible expenses as these are incurred for earning an income. Since Larry is not involved in regular trading of shares, his gain on sale of Goldstar shares is tax-exempt income. His total tax liability for year ended 31 March 2018 is shown below (James, Sawyer & Budak (ed), 2016).

Yes, this is absolutely correct and in the commercial world this is considered as a thumb rule by all those aspiring business men. No business is started without the thought of earning a profit. Although, for a startup business there can be periods when it does not make any profit. And the IRD too makes a distinction between a legitimate business and a hobby activity solely on these grounds for the purpose of taxation. If an activity is being carrying on as a legitimate business, it can deduct the business expenses incurred for running of that business. Under difficult circumstances, the owner may book a loss as the earnings are less than the expenses but that does not imply that the business cannot be profitable (Littlewood & Elliffe (ed), 2017).

IRD does keep a watch on the activities of taxpayers and those regularly filing income tax returns showing loss are bound to be put under scrutiny after two or three loss showing tax returns. If a business promoter does not show a profit during the first two years of running the business but if he optimistic of a profit in the third year it is fine to declare business losses on tax returns (CCH New Zealand (ed), 2013; CCH New Zealand Ltd (ed), 2013). But if no profit accrues in three or more years of running the business, the IRD can assume that it is not a business but a hobby. Being engaged in a hobby, the entrepreneur is not allowed by the IRD to claim expenses and declare a loss for the sake of saving on tax payments. IRD does not allow an entrepreneur to remain engaged in a hobby and keep on claiming expenses to be offset against other incomes (CCH New Zealand (ed), 2013; CCH New Zealand Ltd (ed), 2013). The IRD terms this as hobby loss rule.

Legitimacy of Business versus Hobby

The IRD has a set the following guidelines for determining whether the activity being carried on is a legitimate business or just a hobby and I quote:

Although Eric is an occasional hunter and carries on this activity as a recreation, he cannot deny that this activity is not bringing in money for him. He declares that he occasionally sells the excess meat, which his family cannot consume, to his friends and acquaintances (Ganghof, 2006). This surely brings in the element of business to his recreational activity. Although Eric is concentrating only on one aspect of the business, that is earnings, as he does not count the expenses which he may be incurring for carrying out the hunting activity. That may make him less of a businessman and more of a person engaged in a hobby (Scully & CAragata (ed), 2012).

But from the guidelines which the IRD issues from time to time, it is clear that Eric will be treated as running an enterprise where he is making profits and hence must report these profits in his annual income tax returns (CCH New Zealand Ltd (ed), 2013).

Susan is said to be a home baker and is supposedly carrying on the activity of baking cakes at her home for birthdays and special events of known friends, relatives and acquaintances. Susan is not offering her cooking expertise free of charge. Her cakes are being bought by her friends and relatives who like to pay her. Although Susan is not charging extra money for her own labour, she wants that she should be compensated for the ingredients which go into making the cake (CCH New Zealand Ltd (ed), 2013). So, Susan is not concentrating on one aspect of the business, that is profits, but she is interested in getting her expenses covered which she is incurring for making of the cakes. That makes Susan less of a hobby pursuer and more of a businesswoman engaged in an activity which she is pursuing like a business (CCH New Zealand Ltd (ed), 2013).

From the IRD guidelines, which are issued from time to time, it can be clearly deduced that Susan should be treated as running an enterprise where maybe she is not making big profits but is definitely not reporting these small profits in her annual income tax returns.

Mike owns a Harley-Davidson Roadster motorbike which he uses for personal as well as business use. During the financial year 2017-18, expenses incurred on maintenance of this motorbike were –

Fee for Registration and Fitness Warrant – $250.00 (paid from business A/c)

Insurance Premium     – $1,400.00 (paid from personal A/c)

Mike considered that the running and maintenance costs of this motorbike could be distributed as –

For Business purposes – 1/3^rd

For Personal purposes – 2/3^rd 

The above expenses will be put into personal account and business account in the following proportions –

Personal A/c Business A/c

Registration fee $83.35 $166.65

Insurance Premium $466.65 $933.35

• Expenses of self-owned Toyota Hi-Ace van

The three month’s log book readings show that of the total of 3,219km run by the van, 1,246km (38.70%) was for business use and 1,973km (61.30%) was for personal use. In whole of the FY 2017-18, the van did 14,492km and the total cost incurred on running and maintenance of the van was $5,377 (Littlewood & Elliffe (ed), 2017). This amount will be put into personal account and business account in the following proportions –

Personal A/c Business A/c

Running Cost of Van $3,296.10 $2,080.90

• Depreciation on the second-hand van will be calculated at the Total Purchase Cost of –

Cost of Van $18,648.00

Freight & Insurance $1,420.00

On-Road Costs $850.00

TOTAL COST $20,918.00

Depreciation @15% for

• The cost of $350 for work clothing will be fully allowed as deductible expense. But the cost of $800 for the leather jacket will allowed for 1/3^rdcost, as that is the usage of Mike’s bike for business purposes (Littlewood & Elliffe (ed), 2017).
• Estimated usage of phone is 80% for business purposes, hence, deductible expense will be $45*80% = $36*10.5 months = $378.00.
• It is not on the basis of time spent but on the proportionate area of usage, which is 66.65% (150/225) for workshop use and 33.35% (75/225) for personal use. Hence, the deductible expense will be 750*66.65% per week = $499.88 per week = $25,993.50 per annum (James, Sawyer & Budak (ed), 2016).
• Winning or losing is part of any competition, but Mike will be allowed deduction of the expenses which he incurs on preparation and participation of the car race.
• Cost of providing morning tea/coffee and biscuits to the staff is allowed as a deductible expense in all organisations in New Zealand. But the cost of serving food and alcohol on a Friday night to staff is not permissible as deduction.
• Business purpose meetings and expenses related to such meetings are for the purpose of increasing the income potential of the organisation. Hence this expense will be allowed as deductible (James, Sawyer & Budak (ed), 2016).
• Since Mike was rushing to conclude a business deal, this penalty will be treated as a business enhancing expense and allowed as a deduction.
• 60% (4 days out of 7 days) of Mike’s stay in Sydney was on account of business promotion but 40% (4 days out of 7 days) was for pleasure. Moreover, the amount spent on alcohol in pubs and bars is totally for personal pleasure, hence is completely not deductible. 60% of the balance amount of $5,794 will be allowed as deductible expense (Lymer & Hasseldine (ed), 2012).
• These expenses are for repairing the workshop and machinery, hence will be permissible in total.
• Mike had inserted 8 advertisements in the magazine, of which only 2 (for Feb. & Mar. 2018) can be charged as expense in the current income year. The remaining 6 will be included in expenses of next income year (Ganghof, 2006).
• All these tools and machinery will be included in the Low Pool Asset Table and depreciated at the given rates.
• This is furniture for office use and the items shall be depreciated as per rates given (CCH New Zealand Ltd (ed), 2013).
• The loss of $2,000 from sale of the machine will be taken as deductible expense.
• Mike will book a profit of $4,530 on the sale of this machine, as explained below.

LESS: Depreciation Claimed $2,750.00

Opening Value at the beginning of 2017 $6,750.00

Sold on 30 Sept. 2017 for $11,565.00

Profit Earned $4,815.00

LESS: Freight Charges $285.00

Net Profit booked in tax return $4,530.00

• The printer and the ink can be claimed as deductible expense in this year as both the items are low cost and consumables.
• Although Mike will be booking a loss on the stolen bike, it will be booked in the next income year as Mike will be receiving the compensation in May 2018.

References

CCH New Zealand Ltd (ed). (2013) New Zealand Goods and Services Tax Legislation (2013 edition). Auckland: CCH New Zealand Limited.

CCH New Zealand Ltd (ed). (2013) New Zealand Income Tax Act 2007 (2013 edition). Auckland: CCH New Zealand Limited.

CCH New Zealand (ed). (2013) New Zealand Master Tax Guide (2013 edition). Auckland: CCH New Zealand Limited.

CCH New Zealand Ltd (ed). (2013) New Zealand Tax Regulations and Determinations (2013 edition). Auckland: CCH New Zealand Limited.

Ganghof, S. (2006) The Politics of Income Taxation: A Comparative Analysis. Colchester: ECPR Press.

James, S., Sawyer, A. and Budak, T. (ed). (2016) The Complexity of Tax Simplification: Experiences From Around the World. Hampshire: Springer.

Littlewood, M. and Elliffe, C. (ed). (2017) Capital Gains Taxation: A Comparative Analysis of Key Issues. Cheltenham: Edward Elgar Publishing.

Lymer, A. and Hasseldine, J. (ed). (2012) The International Taxation System. New York: Springer Science & Business Media.

Scully, G.W. and CAragata, P.J. (ed). (2012) Taxation and the Limits of Government. New York: Springer Science & Business Media.