It’s TaxQuips time from TaxMama.com® .
Today TaxMama® wants to talk to you about your business.
Dear Family,
We are getting a lot of questions from tax pros and taxpayers about businesses that keep showing losses. Is the IRS going to look at them and disallow them as businesses – treating them like hobbies?
First let me explain why this is important from a tax reporting perspective.
- A business can deduct all its legitimate operating expenses from the business’ sales and income – either on a Schedule C, or a business entity return (partnership, corporaton, etc.) and deduct losses, as appropriate.
- However, with a hobby, you must report all your income (on Schedule 1) – but you may not deduct your opertating expenses at all. Nowhere. Not on any form. The only thing you may deduct are your cost of goods sold. In other words, hobbyists that lose money don’t get to deduct expenses OR losses.
OK, so what distinguishes a business that keeps losing money, from a hobby?
The Internal Revenue Code lists 8 primary characteristics of a real business in IRC §183. https://www.law.cornell.edu/uscode/text/26/183
I could spend about 4-8 hours explaining the rules, nuances and ways to ensure your business is not a hobby (and often do teach that concept).
But here are some fundamentals:
- You have a regular job, with a W-2, making enough money to live on – but your business always shows losses. HOBBY.
- The business gives you an opportunity to indulge in an expensive interest (horses, boats, travel, race cars) – and you have heard you can write off the costs. HOBBY.
- Your business keeps showing losses, but you don’t do anyting different from year to year to make it profitable. HOBBY.
- That can be paraphrased as the definition of insanity: “Someone who keeps doing the same thing over and over again – but expects different results.”[1] (The IRS subscribes to this concept)
- The business doesn’t have a business plan that is reviewed regularly and the business takes steps to change their marketing approach, product mix, pricing, staffing, etc. to become profitable in the next quarter. HOBBY.
- The business expects to show losses for several years due to the nature of their developing product or market (like inventions and manufacturing processes) – and they have a business plan that defines when they expect to be profitable. BUSINESS.
- The business does everything correctly, but an outside force intervenes – and they end up with losses. (A valuable breeding horse dies – and there goes their entire livelihood.) BUSINESS
- The owners are putting significant time into the business, but they don’t have the capital or financing to make it profitable as quickly as they would like. BUSINESS.
- The business is based around a valuable asset that keeps appreciating. So even if the business itself fails – selling the asset will cover all the earlier losses. BUSINESS.
- One more situation – you have no other income, but the business keeps showing losses. What are you living on? In this case, it might be worse than just being a hobby – it might look like substantial unreported income. TAX FRAUD.
As you can see, there are several instances where a business that keeps showing losses can survive IRS scrutiny. In all cases – it involves doing regular tax planning, business planning, and knowing when and how to reposition the business’ focus.
The first three chapters of Small Business Taxes Made Easy deal with this very concept. https://yourbusinessbible.com/
Hobby loss audits happen to be one of my favorite areas of tax representation. In each case, I have been able to help my clients build convincing documentation to substantiate their honest-to-goodness business intent.
Incidentally, since this is National Small Business Week, the IRS website has outlined some really useful tools for you relating to the life cycle of a business.
https://www.irs.gov/newsroom/national-small-business-week-irsgov-offers-a-z-resources-for-small-businesses
And remember, you can find answers to all kinds of questions about taxes and business issues, and EA Education, free. Where? Where else? At http://iTaxMama.com/AskQuestion
[1] Often attributed to Albert Einstein – but, apparently, the source is mystery novelist Rita Mae Brown.
https://www.businessinsider.com/misattributed-quotes-2013-10
