Many people dream of turning a hobby into a regular business. Perhaps you enjoy boating and would like to open a charter fishing business. Or maybe you’d like to turn your sewing or photography skills into an income-producing business.

You probably won’t have any tax headaches if your new business is profitable over a certain period of time. But what if the new enterprise consistently generates losses (your deductions exceed income), and you claim them on your tax return? You can generally deduct losses for expenses incurred in a bona fide business. However, the IRS may step in and say the venture is a hobby — an activity not engaged in for profit — rather than a business. Then you’ll be unable to deduct losses.

By contrast, if the new enterprise isn’t affected by the hobby loss rules, all otherwise allowable expenses are deductible, generally on Schedule C, even if they exceed income from the enterprise.

Important: Before 2018, deductible hobby expenses could be claimed as miscellaneous itemized deductions subject to a 2%-of-AGI “floor.” However, because miscellaneous deductions aren’t allowed from 2018 through 2025, deductible hobby expenses are effectively wiped out from 2018 through 2025.

How to NOT be deemed a hobby

There are two ways to avoid the hobby loss rules:

1. Show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing, or racing horses).
2. Run the venture in such a way as to show that you intend to turn it into a profit maker rather than a mere hobby. The IRS regs themselves say that the hobby loss rules won’t apply if the facts and circumstances show that you have a profit-making objective.

How can you prove you have a profit-making objective? You should operate the venture in a businesslike manner. The IRS and the courts will look at the following factors:

• How you run the activity,
• Your expertise in the area (and your advisors’ expertise),
• The time and effort you expend in the enterprise,
• Whether there’s an expectation that the assets used in the activity will rise in value,
• Your success in carrying on other activities,
• Your history of income or loss in the activity,
• The amount of any occasional profits earned,
• Your financial status, and
• Whether the activity involves elements of personal pleasure or recreation.

Case illustrates the issues

In one court case, partners operated a farm that bought, sold, bred, and raced Standardbred horses. It didn’t qualify as an activity engaged in for profit, according to a U.S. Appeals Court. The court noted that the partnership had a substantial loss history and paid for personal expenses. Also, the taxpayers kept inaccurate records, had no business plan, earned significant income from other sources, and derived personal pleasure from the activity. (Skolnick, CA 3, 3/8/23)

Contact us for more details on turning a hobby into a business, including whether you may be affected by the hobby loss rules and what you should do to avoid tax problems.

Earth Day (April 22) is a good time to evaluate what your business can do to protect the planet’s natural resources for the next generation. “Green” initiatives can demonstrate your company’s commitment to responsible business practices — as well as lower your monthly bills.

For many small and midsized businesses, utilities and fuel are significant monthly expenses. In recognition of Earth Day, here are six cost-effective ways to rethink energy usage and boost your bottom line:

1. Install smart thermostats.

This can save on heating costs in the winter and cooling costs in the summer. Smart thermostats adjust energy usage based on the presence of employees, the time of day, and your temperature preferences. Smart thermostats that meet Energy Star criteria save users an average of 8% on their utility bills, according to the U.S. Environmental Protection Agency.

You also might consider adjusting your current temperature settings by a degree or two (higher in the summer and lower in the winter) and programming thermostats to energy-saving mode during nonwork hours. Minor changes will compound over time.

2. Insulate and seal your facilities.

Heating and cooling systems can be particularly costly in uninsulated, leaky buildings. Installing spray foam and replacing old seals or adding new ones can dramatically reduce energy costs.

3. Invest in energy-efficient fixed assets.

Technological advances allow today’s equipment to consume less energy than older versions. Examples of older equipment that you should consider replacing with models that carry the Energy Star label include printers, copiers, scanners, computers and monitors.

Likewise, if your employees drive company vehicles or use gas-powered machinery or tools, consider efficiency ratings when it’s time to replace these assets. In some cases, it might make sense to switch to electric or hybrid alternatives.

4. Stay atop HVAC maintenance.

Heating, ventilation, and air conditioning (HVAC) systems depend on the unimpeded movement of air. Annual checkups can reveal blockages or leaks that can put additional stress on the equipment. Cleaning and replacing filters, as recommended, can also help lower energy usage.

5. Install LED lighting.

Light-emitting diode (LED) lighting is more energy efficient and lasts longer than regular incandescent lighting. LED lights are also easily dimmed, reducing the cost of lighting a space. Plus, LED lights emit less heat than incandescents, which can help lower room temperature in the summer.

6. Conduct an energy audit.

Audits can uncover areas of excessive usage and waste. While some utility companies offer free on-site consultations, third-party energy audit firms are a more comprehensive option. The audit process begins by establishing baseline expenses for such items as:
• Electricity,
• Natural gas,
• Fuel,
• Water, and
• Solid waste.

To prepare for an energy audit, you’ll need to gather these monthly expenses from the last two or three years. Looking back can help identify any variances, allowing you to investigate the root causes. You’ll also need to gather maintenance records and specifications — including square footage, year of construction, usage and operating hours — for each facility you operate. A list of energy-consuming assets — such as machines, equipment, lighting and HVAC systems, and vehicles — is also essential. The auditor will physically inspect your facilities and interview employees to identify problem areas and recommend potential energy-saving opportunities.

Go green, save green

While some of these recommendations require an investment, the cost savings can be significant and long-lasting. Contact us to discuss ways to lower your company’s energy costs and boost profits, including information about potential tax breaks that may be available for green improvements.

Inventory management is a key balance sheet item for many companies. Depending on the nature of your operations, inventory may include raw materials, work-in-progress (WIP) inventory, and finished goods. While you need to have enough inventory on hand to meet your customers’ needs, carrying excessive amounts can be costly. Here are some smart ways to manage inventory more efficiently — without compromising revenue and customer service.

Reliable counts

Effective inventory management starts with a physical inventory count. This exercise provides a snapshot of how much inventory your company has on hand at that point in time. For example, a manufacturing plant might need to count what’s on its warehouse shelves, on the shop floor and shipping dock, on consignment, at the repair shop, at remote or public warehouses, and in transit from suppliers and between company locations.

The value of inventory is always in flux, as work is performed and items are delivered or shipped. To capture a static value as of the reporting day, companies may “freeze” business operations while counting inventory. Usually, it makes sense to conduct counts during off-hours to minimize the disruption to business operations. For larger organizations with multiple locations, it may not be possible to count everything at once. So, larger companies often break down their counts by physical location.

Accuracy is essential to knowing your cost of goods sold, as well as to identifying and remedying discrepancies between your physical count and perpetual inventory records. Possible reasons for discrepancies include:

• Data entry errors,
• Inaccurate bin or part numbers,
• Shipping errors,
• Inventory in the authorized possession of employees (such as owners or salespeople),
• Theft, and
• Intentional financial misstatement.

It’s important to identify what’s happening and resolve any problems or errors.

Benchmarking studies

The next step is to compare your inventory costs to those of other companies in your industry. Trade associations often publish benchmarks for:

• Gross margin [(revenue – cost of goods sold) / revenue],
• Net profit margin (net income/revenue), and
• Days in inventory (annual revenue / average inventory × 365 days).

Your company should strive to meet — or beat — industry standards. For a retailer or wholesaler, inventory is simply purchased from manufacturers. However, inventory is more complicated for manufacturers and construction firms. These entities must allocate costs to projects that are in progress.

Efficiency measures

What can you do to improve your inventory metrics? The composition of your company’s cost of goods will guide you on where to cut. In today’s tight labor market, it may be difficult to reduce labor costs. But it may be possible to renegotiate prices with suppliers.

And don’t forget the carrying costs of inventory, such as storage, insurance, obsolescence, and pilferage. You can also improve margins by negotiating a net lease for your warehouse, installing antitheft devices, or opting for less expensive insurance coverage.

To cut your days-in-inventory ratio, compute product-by-product margins. You might stock more products with high margins and high demand — and less of everything else. Consider returning excessive supplies of slow-moving materials or products to your suppliers, whenever possible.

Product mix can be a delicate balance, however. It should be sufficiently broad and in tune with consumer needs. Before cutting back on inventory, you might need to negotiate speedier delivery from suppliers or give suppliers access to your perpetual inventory system. These precautionary measures can help prevent lost sales due to lean inventory.

Inventorying your inventory

Management often focuses on growth and puts inventory management on the back burner. This can be a costly mistake. Contact us for help researching industry benchmarks and calculating inventory ratios to help minimize the guesswork in managing your inventory.

External auditors spend a lot of time during fieldwork evaluating how businesses report work-in-progress (WIP) inventory. Here’s why this warrants special attention and how auditors evaluate whether WIP estimates seem reasonable.

Valuing WIP

Companies may report various categories of inventory on their balance sheets, depending on the nature of their operations. For companies that convert raw materials into finished goods, a key element is WIP inventory. This refers to partially finished products at various stages of completion. Management uses estimates to determine the value of WIP. In general, the more materials, labor, and overhead invested in WIP, the higher its value.

Most experienced managers use realistic estimates, but inexperienced or dishonest managers may inflate WIP values. This can make a company appear healthier than it really is by overstating the value of inventory at the end of the period and understating cost of goods sold during the current accounting period.

Accounting for costs

Companies assign costs to WIP depending on the type of products they produce. When a company produces large volumes of the same product, they allocate costs as they complete each phase of the production process. This is known as standard costing. For example, if a production process involves six steps, at the completion of step two the company might allocate one-third of their costs to the product.

On the other hand, when a company produces unique products — such as the construction of an office building or made-to-order parts — it typically uses a job costing system to allocate materials, labor, and overhead costs as incurred.

Auditing WIP

Financial statement auditors closely analyze how companies quantify and allocate their costs. Under standard costing, the WIP balance grows based on the number of steps completed in the production process. Therefore, auditors analyze the methods used to quantify a product’s standard costs, as well as how the company allocates the costs corresponding to each phase of the process.

With job costing, auditors analyze the process to allocate materials, labor and overhead to each job. In particular, auditors test to ensure that costs assigned to a particular product or projects correspond to that job.

Recognizing revenue

Auditors perform additional audit procedures to ensure that a company’s recognition of revenue complies with its accounting policies. Under standard costing, companies typically record inventory (including WIP) at cost, and then recognize revenue once they sell the products. For job costing, revenue recognition typically happens based on the percentage-of-completion or completed-contract method.

Get it right

Under both the standard and job costing methods, accounting for WIP affects the balance sheet and the income statement. Contact us if you need help reporting WIP. We can help you make reliable estimates based on your company’s specific production process.

Managing accounts receivable can be challenging, especially in an uncertain economy. To keep your company financially fit, it’s a good idea to occasionally revisit your billing and collections processes to ensure they’re as efficient and effective as possible. Consider these helpful tips.

Resolve billing issues quickly 

The quality of your products or services, and the efficiency of order fulfillment and distribution processes, can significantly impact collections. When an order arrives damaged, late, or not at all, the customer has an excuse to question or not pay your invoice. Other mistakes include incorrectly billing a customer or failing to deliver on promised discounts or special offers.

Make sure you resolve billing mistakes quickly and ask customers to pay any portion of the bill they’re not disputing. Once the matter has been resolved and the product or service has been delivered, ask the customer to pay the remainder of the bill. Depending on the circumstances, you also may consider asking the customer to sign off on the matter by making a note on the final invoice. Doing so will help protect you from potential future claims.

A lengthy cycle time for resolving billing disputes can have ripple effects on finance and accounting processes, such as reporting and forecasting. For instance, if you prepare your first quarter financial statements with numerous outstanding adjustments, management won’t be able to evaluate first quarter results until the adjustments are made. Delays in financial reporting can lead to missed business opportunities and postpone detection of impending financial problems.

Send timely invoices

If you haven’t already done so, implement an automated collection system that generates invoices when work is complete, flags problem accounts, and produces useful financial reports. Consider sending invoices electronically and enabling customers to pay online. You can still send statements out monthly as a routine reminder of outstanding balances.

Delays in invoicing can impair collection efforts. Familiarize yourself with industry norms before setting payment schedules (whether they’re on 30-, 45- or 60-day cycles). If your most important or largest customers have their own payment schedules, be sure to set them up in your system.

It’s also important to regularly verify account information to ensure invoices and statements are accurate and they get into the right hands. Set clear standards and expectations with customers — both verbally and in writing — about your credit policy, including pricing, delivery and payment terms.

Consider rewards for early payment and penalties for delays

Despite your best efforts, you’re still likely to encounter slow-paying customers. Here are some ideas to encourage timely payments:

• Request payment up front with deposits or service retainers,
• Reward timely payments with early-payment discounts, and
• Provide incentives to customers that improve their payment practices.

If positive reinforcement isn’t working, consider implementing late-payment penalties. For instance, you could assess fees on past-due accounts. You might also put a credit hold on extremely delinquent accounts or adjust their payment terms to cash on delivery.

Stay connected with high-maintenance customers

Make regular calls and send e-mail reminders to customers who haven’t settled their accounts. If necessary, the manager who works directly with the customer should try to resolve the payment issues with the lead contact at the company — or even the owner. Consider executing a promissory note to prevent the customer from disputing the charges in the future. If your efforts aren’t fruitful, get help from an attorney or collection agency. Keep in mind, though, that third-party fees may consume much of the collected amount.

If an outstanding debt is uncollectible, you can write it off as an ordinary business expense. Be sure to document customers’ promises to pay and your collection efforts, as well as why you believe the debt is worthless.

We can help

Solid billing and collections strategies are integral to a company’s financial health. Contact us for more ideas for improving your company’s approach to accounts receivable.