CRITICAL STEPS TO MAINTAINING BUSINESS STATUS WITH THE IRS
By: Sandy Botkin, C.P.A.
So, you finally decided to start your own part-time home business. You have gathered sufficient inventory and equipment to run it. You have a marketing plan of attack to make lots of money, and all you need to do to keep the IRS off your back is save all receipts, right? WRONG!!
One of the IRS’s favorite weapons is to treat a home business as a hobby, not as a legitimate business. Even if you have all the receipts in the world, classification of your endeavor as a hobby will limit your “business” deductions to the income from the activity. If the deductions exceed your activity’s income, the excess is completely eliminated!
If, however, your endeavor is classified as a business and generates a loss in the first couple of years, you can subsidize your business by reducing the taxes you pay on any other source of income such as your wages, rents, dividends and pensions. You can even even reduce the tax that your spouse would pay on his or her salary. In addition, if your losses exceed your family’s income, you can either carryback the loss three years and get a refund from the IRS, or carry it forward 15 years and offset up to the next 15 years of income. Thus, knowing how to maximize the chances your endeavor will be treated as a business makes a difference as to whether your activity survives.
The following example will explain this:
Example: Wayne incurred a $10,000 loss from his part-time business. If he earns $40,000 as an employee, his taxable income for the year will be only $30,000. If, however, the IRS classifies his ”business” as a hobby, he will not be able to use the $10,000 loss and will have to pay tax on the full $40,000.
Thus, the real question is when are you conducting a business vs. a hobby?
The good news is that there is a safe harbor area which, if met, puts the burden of proving your activity is not a business on the IRS. Generally, if you have a profit in three out of five consecutive years, the IRS has the burden of proving your activity constitutes a hobby.
TIP: Once a profit is shown to occur in three out of five consecutive years, the IRS rarely, if ever, challenges the endeavor as a hobby.
The problem is that in these cases, the IRS rarely waits the full five years to see if you have a profit. Congress, therefore, provides an election to file with your tax return to force the IRS to wait the requisite time period.
TIP: Although this election sounds good on paper, don’t bank on it. It calls attention to your return and extends the statute of limitations for the IRS to catch you.
Thus, if you don’t have a profit in the requisite time period, what happens? This is purely a myth. The IRS states in its regulations that as long as you operate your endeavor as a business in the pursuit of profit, you can still claim all business losses generated, without limit.
Unfortunately, there is no safe harbor here, just some guidelines. However, if you review the following criteria carefully, you should be able to overcome almost any challenge.
Criterion One: What were your motives at the time you entered into the activity?
You need to document your intent to investigate this activity as to its profitability. Feasibility studies, consultations with experts, and documented financial statements of similar activities help establish that you entered your activity to pursue a profit.
It is also vitally important to prepare a business plan for at least five to ten years. This plan shows the estimated income and expenses over the foreseeable ten years.
Criterion Two: Did you make any statements or did any statements in the marketing materials indicate a not-for-profit motive?
The IRS will generally not believe your own self-serving statements that you entered your activity to make money. However, any statements made to the contrary, will be held against you. Don’t ever tell anyone you entered the activity simply to save taxes or get some discounts. The IRS will use your own statements against you.
Criterion Three: Do you conduct your activity in a business-like manner?
Businesses generally keep good accurate records, hobbies don’t. You should have a separate bank account (with no co-mingling of personal funds) for your business. You should use the financial statements generated each year to prepare a budget so you can try to reduce expenses, and most importantly, you need to keep a good tax diary of your mileage, appointments, entertainment and travel expenses.
Tip: A good tax diary is one of the most important audit-proof documents you can have. It documents appointments, mileage, entertainment and travel reasons and expenses. This is one item all business people cannot do without.
Criterion Four: Do you run your endeavor like a similarly profitable business?
You should try to show that your activity is carried on in a similar manner to other profitable ventures.
Thus, you would want to show you advertise your business, print up business cards and stationery with your address and phone number, develop promotional literature, maintain a business telephone listing, and use a variety of marketing strategies.
Criterion Five: What was your prior business experience?
If you have no prior experience doing this activity, it becomes more questionable as to whether you ever had a profit motive. This can be overcome, however, with proper documentation showing you did extensive investigation of the activity before starting it, you participated in extensive training and study to make the activity a success, and attended a number of seminars in your field of endeavor.
TIP: You can never get enough training, especially if you have no prior experience in this field.
Criterion Six: What is your history of losses and income and what steps did you take to improve your profitability?
This is a major factor with the IRS. You should do almost anything legally and morally necessary to turn any business losses into profits. Again, it is essential to document all training taken, consultations with experts, marketing activities, reasons for business trips, noting the intent and necessity for making the trip.
Criterion Seven: Do you devote some time in a regular manner to your activity?
Although you certainly do not need to devote full-time to your business, the more time and effort, the better. Cases have shown that as little as one hour per day (or more) on the average can be sufficient to support a profit motive.
Observation: Businesses are conducted regularly, hobbies are not. One hour a day for four days a week is better than eight hours every two weeks.
Criterion Eight: What is the amount of income from other sources?
The greater your income from other outside sources such as wages, pensions, etc., the less likely your loss from your activity will be deemed a business loss.
Criterion Nine: Are you in an inherently suspicious activity? The purpose of the hobby loss provisions is not to eliminate losses from businesses no matter how poorly run. It is designed to attack people who are starting a business as a sort of “tax shelter.” There are some activities that get closer scrutiny than others such as: antique collecting, stamp collecting, traveling, ministerial duties, writing, racing, training, record recording and other similar ventures. If you are attempting any of these, you must dot your i’s and cross your t’s. HBM
Sandy Botkin CPA, Esq., is the president of the Tax Reduction Institute (TRI Seminars) of Germantown, Maryland. He provides continuing education seminars for real estate professionals nationwide and is the author of the acclaimed series, ”Tax Advantages for Home Based Business” and “How To Sell More Real Estate Using Tax Knowledge” He is also the author of the article, “How to Analyze a Good Network Marketing Opportunity”. You can order either of his nationally acclaimed tax systems by calling 602-874-1719. For questions on his seminars, booking a seminar or getting a copy of his article on home-based business, call 301-972-3600.