Question

Ashley Fraud, a partner at a major Los Angeles law firm, earned $300,000 in salary for Year One. In addition to her work as an attorney, Ashley owns a bakery business to which she devotes only 50 hours annually. In Year One, the bakery yielded a $30,000 loss. In the same year, Ashley received royalty income of $10,000 from a hit song she recorded with her family years earlier.

(a)  To what extent may Ashley deduct the $30,000 loss from her bakery business in Year One?

(b)  In Year Two, Ashley sold the bakery to an unrelated buyer at a realized gain of $100,000. What tax consequences arise?

(c)  Same as (b), except that instead of selling the bakery, Ashley held onto the business and saw it generate some dough: the bakery made a profit of $10,000.

(d)  How would the answer to (a) change if Ashley worked at the bakery for 300 hours in Year One, an amount in excess of that worked by any other person involved with the bakery?

(e)  How would the answer to (a) change if Ashley also owned and operated a cinema in which she did not materially participate and that activity yielded a profit in Year One of $20,000?

Answer 1

a) Since Ashley devotes only 50 hours annually to her bakery business the loss from bakery business should be considered as passive activity and such loss can only be offset with income from such activity.Since Ashley received royalty income of $ 10,000 which again can be categorized as passive income.Hence in year one $ 10,000 can be offset.

b) Income arising from sale of bakery is long term capital gain and is taxed accordingly.Loss is NOL (Net operating loss) from business cannot be offset with Long term capital gain as Long term capital gain is taxed separately.

c) The profit of $ 10,000 can be offset with the loss that Ashley incurred.

d) If Ashley worked from over 300 hours in bakery the profit / loss would be termed as active and can be offset with active income. Income from salary is also an active income and hence the loss of $ 30,000 can offset with salary income.

e) If Ashley did not materially participated the income derived from it would be termed as passive hence $ 20,000 earned from it plus income from royalty $ 10,000 together would be available to offset the loss of $ 30,000 incurred from bakery. business.