Organizing Business Income and Expenses for Tax Purposes Part 1

by David Jon Fischer

Income taxes paid by any business is on the net income earned by the business. This includes all balloon-related businesses. Revenues minus expenses equal net income; net income minus income taxes paid equals net profits. The application of this general formula varies slightly with each form of business organization whether it is organized as a proprietorship, partnership, corporation, limited liability company or some other joint venture. To compute these elements, the business must keep complete and accurate records of revenues generated and expenditures made by the business. A recordkeeping system is therefore essential to this task. Federal income tax laws require the taxpayer to keep complete records for a tax year for three years after filing a tax return; these records are kept even longer for cash investments, real estate, building and equipment purchases, and other activities.

What is Income?
To identify what records are pertinent, it is necessary to know what federal law considers to be income and deductible expenses. The Internal Revenue Code defines "income" to include all receipts despite its nature, unless the law specifically excludes the receipt as income. This includes:

Compensation for services (i.e., wages or salary, whether paid in cash or as barter).
Fees or commissions.
Profits or losses from a business (including distributions of shares of partnership or company income or losses, or of corporate dividends or profit shares).
The increase in value paid to the taxpayer from sold or exchanged property.
Interest from dividends.
Rents.
Royalties.
Annuity or pension payments.
Constructive income due to the discharge of debt.
Distributed shares of estate or trust income.
Windfall gains.
Any source of illegal income.

Income can be received as money, property, or services. Bartering of goods or services is income to the recipient at the fair market value of the goods or services he or she received in the exchange. (Bartering is the exchange of services or goods or other property that does not involve cash.) The following are examples of income received in a typical commercial ballooning business:

Chartered passenger flights for a fee.
Commercial tether promotions for a fee.
Pilot race or show-up fees (but expenses at event are generally deductible).
Sale of envelope banners.
Resale of propane above pilot’s cost to others.
Repair station fees for repairs, inspections and other similar activities.
Flight instruction or ground instruction fees.
Sales of balloon accessories and equipment.
Sale of new or used hot air balloons (whether as dealer, distributor or manufacturer).
Balloon race promotion fees.
Commercial advertising services contract.

Unlike expenses, where the taxpayer must show that the deduction is allowed, the tax laws require the taxpayer to show that the receipt is not taxable income. It may sound odd, but just keep in mind that the presumptions are designed to force the taxpayer to maximize the income upon which he or she must pay taxes.

Treatment as hobby or business
Any discussion of income and expenses, particularly for part-time balloon-related businesses, must include a federal tax rule of importance: Income from a hobby is taxable; losses from a hobby are not deductible. An overall "no profit" computation for a business can occur for tax purposes because of "non-cash"-type deductions, such as depreciation, or the use of office space in the home (though this deduction is limited to avoid this result). When these "non- cash" deductions are added to "cash paid" deductions, and they exceed the amount of income received in the business, there is a loss for income tax purposes and no taxes will be paid or it will offset other net income. This situation frequently occurs during the first few years of a business. For example, an aeronaut who obtains a commercial rating often has owned a balloon for some time, and thus, does not need to purchase a new balloon. Under federal tax law, if that balloon is contributed by the pilot to a business as an asset, especially if the business is a partnership or corporation, the business can begin to depreciate the balloon as a business asset using the fair market value of the balloon at the time the business use began. Though, from a "cash in-cash out" point of view, the pilot has more cash than he or she started with, from a tax perspective the non-cash deductions resulted in a loss. In any event, when the business shows a profit, the expenses are deducted from revenue, and there will always be some net income on which income taxes are paid. On the other hand, if the activity is a hobby, and expenses exceed income, then the law will not permit the expenses to be deducted if they will create an income loss; and if losses are claimed for a hobby, they will be disallowed by the IRS on a tax audit. One test used in the Internal Revenue Code to decide if an activity is a hobby or a business is whether profits are being generated in three of the preceding five years. If this is the case, then there is a tax law presumption that the activity is not a hobby. If the business is less than five years old, or if profits were not shown for three years, the IRS may choose to treat the activity as a hobby and limit any deductions to income earned. Special rules and procedures apply that allow recomputation of tax liability based on being a business after the five year period has passed. In addition, the existence of the activity as a business than as a hobby also can be proved through the existence of complete and timely business records, the expertise of the taxpayer and his advisors, the time and effort expended in the activity, the expectation that assets used in the activity will appreciate, past success in other similar or dissimilar activities by the taxpayer, current financial status, and whether there is a presence of "personal pleasure and recreation" in the activity. In Part 2 of this series, we will look at the specific expense categories that can be used by businesses on the different tax return forms.