Tax Breaks from Retirement Activities

More and more retirees stay active. Some work or start businesses. Some have hobbies. Technology and other changes in the economy make it possible for more and more seniors to pursue avocations. But too many seniors overlook big tax breaks from these activities.

Over the years I’ve driven through the horse country of Virginia many times. I once marvelled at how people could afford expensive estates for part-time use and wondered why there always were a few horses or cattle on the land. Since then I’ve learned that these property owners know the tax law. They can afford these part-time estates because they are paid for with after-tax dollars.

The cows and horses are on the properties to convert the estates into businesses. That makes all the expenses of owning and running the properties deductible against the business’s income. In addition, any losses from the activity can be deducted against other income.

That’s quite a turnaround. A cash drain becomes a cash cow by generating tax losses that can be deducted against other sources of income. If the business becomes profitable, tax-free benefit plans and a pension plan can be established, relatives can be put on the payroll, and other tax-wise strategies put in place.

This tax benefit is not available only to the very wealthy. Many senior hobbies and avocations can be turned into businesses that generate either tax losses or cash flow.

One big benefit is the Internet. Seniors who create things or perform services can use a website, Ebay, and other tools to find customers worldwide. You don’t have to travel to a lot of trade shows or other events. Most activities can be turned into businesses with fairly small changes in the way the activities are conducted.

Of course, the IRS doesn’t like people to deduct losses against other income, especially when those losses are from part-time businesses or activities the IRS believes are hobbies. Fortunately, the IRS doesn’t always get its way. The rules for justifying your deductions are fairly clear, and the Tax Court sides with the taxpayer when the rules are followed.

The first rule is that you are allowed the loss deductions if you profit in three of any five consecutive years (two of seven for horse businesses). This is known as the safe harbor. It doesn’t matter how much the profit is.

In years when income and expenses are going to be closely matched, you might look for ways to accelerate expenses and defer income to ensure there is a loss for the year. Don’t do anything off the books or that is fraudulent. But there are legitimate ways to manage the recognition of income and expense. Some expenses can be prepaid or purchases accelerated. Sending out bills can be delayed. Consult with an accountant if you aren’t sure which tactics work.

But you can deduct losses without qualifying for the safe harbor or making a profit. Simply establish that you were conducting the business with the intention of making a profit and were running the activity in a business-like and professional manner. Establishing these points takes some work but it is not hard work. Be sure to take these steps:

• Prepare a business plan. Make realistic projections of income and expenses and outline how you intend to profit over time.

• Don’t deduct questionable or borderline expenses. When you have a profitable business, you can put relatives on the payroll (if they do real work for the wages) and deduct a fair amount of business meals and entertainment. But if you are losing money and appear to be pushing the limits on deductions, you’re asking for trouble. Don’t be like the guy who deducted payments to brothels because he said he was researching a book on legal prostitution in Nevada.

• Keep good records. If you don’t have good records, it isn’t easy to show that you are operating the activity in a professional manner. It also won’t be easy to show whether or not you made a profit. Good records of income and expenses are essential.

• Act like a business owner. That means if the business is losing money, make changes designed to improve the profit picture. Consult with experts in the field, attend trade shows, take classes, subscribe to industry publications, hire professionals, and talk to others in the field. Obtain all required licenses and permits.

• Terminate the business if it will never be profitable. Sell it or simply shut it down. Then move on to another activity. Terminating the business is not essential. Taxpayers who never made a profit won Tax Court cases without leaving the business. But it is one more fact that preserves your past tax losses by showing that your intention was to make a profit.

• If you already have a profitable business, it might be possible to start another related business and use its losses to offset income from the profitable activity. The two activities can be treated as one business for tax purposes if there is a close economic relationship and a business purpose for operating them as one activity.

Seniors are more active than ever, and there are many avocations available to them. By all means, do something you enjoy. But if the activity can produce revenue, consider structuring it as a business. Follow the rules, keep the losses from getting too high, and the activity will also enhance your net worth.