Is it a business or a hobby? The IRS has rules

Dear Liz: After accepting a layoff in exchange for a separation package earlier this year, I have started writing articles for a subscription website. My stories have become popular enough that I’m starting to earn some money and expect a 1099-K this year. I have enjoyed the work and want to cultivate a dedicated audience. I need a few things to improve my output (dedicated laptop, improved writing software, etc.). These will cost more than I plan to earn this year from my new gig but I have cash from my severance. What are my best options? Should I wait until I’ve earned enough from writing before purchasing upgrades?

Answer: The IRS doesn’t want people writing off losses if they’re not making a serious effort to make money. This is known as the hobby loss rule.

The agency understands, however, that not every business turns a profit every year and many businesses have significant start-up costs that may exceed their income for a time. Generally, if you make a profit in at least three out of five years, the IRS presumes you’re engaging in a real business rather than pursuing a hobby.

If you’re planning to spend more than you make this year and write off the loss on your taxes, you’ll want to make sure you’re running this new business in a business-like way. Consider hiring a tax pro who can advise you about how to structure your company, keep good records and file estimated tax payments when necessary.

Your tax pro also can make sure you don’t inadvertently over-report your income.

Forms 1099-K are issued by third-party payment networks including Venmo or PayPal to report payments over $600, but those transactions can include personal as well as business payments. A client may have used Venmo to pay you for a story, for example, but you also may have received payments from friends for their portion of a lunch tab. Plus, if that client pays you more than $600 in a year, you’ll also be issued a Form 1099-NEC. You’d be double reporting your income if you used both the Form 1099-NEC and the Form 1099-K.

Inherited IRAs bring a tax bite

Dear Liz: I have an IRA worth over $1 million and am taking required minimum distributions. When my kids inherit this, can they take it all out with no tax issues because it is an inheritance? Or will they have to take required minimum withdrawals when they are old enough?

Answer: Retirement accounts don’t get the favorable step-up in tax basis that other assets typically get when someone dies. Your children will pay income tax on any withdrawals from an inherited IRA and most likely will have to drain the account within 10 years.

In the past, IRA beneficiaries other than a spouse had to start taking required minimum distributions after the account owner’s death. They couldn’t put off required minimum distributions until their 70s, but they could base the distribution amounts on their own life expectancies. The so-called “stretch IRA” let most of the assets continue to grow tax deferred.

But the stretch IRA was eliminated for most beneficiaries by the SECURE Act, which Congress passed in December 2019. The reasoning was that retirement accounts were meant to support the original account owner in retirement, not to provide tax-deferred benefits to their heirs. There are certain exceptions for beneficiaries who are surviving spouses, minors, disabled, chronically ill, or within 10 years of the age of the original account holder.

Social Security death benefits

Dear Liz: My wife was 69 at the time of her passing. She was still working and was not collecting Social Security. I am 72, retired and collecting Social Security. When I spoke with Social Security, I was told that I cannot collect on my wife’s work history. All I qualify for is a $255 death benefit. I asked what happened to her money collected all these years. I was told it goes into a general fund. Is there anything I can get from my wife’s Social Security?

Answer: If your current benefit was larger than the one your spouse had earned before her untimely death, then you were given the correct answer: a $255 death benefit.

People sometimes mistakenly believe that surviving spouse benefits are something they can get in addition to their own benefit. But when one member of a couple dies, the survivor gets only the larger of the two checks the couple was previously receiving.

The taxes we pay into Social Security don’t go into retirement accounts with our names on them — the money goes instead to pay benefits to current retirees. There’s no guarantee that what you get out will be proportionate to what you contributed. Most people will get more from the system than they paid in, but some will get less and some, unfortunately, get nothing.

Liz Weston, Certified Financial Planner, is a personal finance columnist for NerdWallet. Questions may be sent to her at 3940 Laurel Canyon, No. 238, Studio City, CA 91604, or by using the “Contact” form at asklizweston.com.