Posted by Elliot Kravitz, ATP

Hobby vs. Business Losses for Tax Purposes

Hobby vs. Business Losses for Tax Purposes

There is no hard-and-fast method for differentiating between a hobby and a real business based on a tax return. There is no way to tell a business from a hobby except by the use of an overall rule of thumb: If a company reports a net profit in a minimum of least three out of five years. If a business presents a net loss in more than two out of five years, it is presumed to be a not-for-profit hobby.

This rule puts a considerable burden of proof on newly established businesses. On the other hand, the IRS expects new companies to get into a loss. It is usual for a business to experience losses for a year or two before becoming profitable. It is also a possible situation for a company could experience many years of losses before first making a profit.

Some Other Factors Contribute

 If you cannot attain the three-out-of-five-year rule, you might still be fit to prove your motive for profit based on nine other factors: 

1. You do your activity in a businesslike manner. Your intention to make your business profits will be proven by the time and efforts put into it.

2. You rely on the activity as a source of income for your livelihood.

3. Your losses result from circumstances that are beyond your control, or they are considered normal in the start-up phase of your particular choice of business.

4. You change your mode of operation in an attempt to make better profitability.

5. You or your financial advisors possess the essential, necessary knowledge to carry on the action as a successful business.

6. You had success in making a profit with similar activities in the past.

7. If the event makes a profit in some years, the IRS will look into how much of a benefit it makes.

8. You can expect to get a future benefit from the growth of the assets used in the activity.

What Happens If You Are Audited

Getting an audit to defend your business losses can be expensive and time-consuming. You lose; the IRS will not permit your business loss. Your business expenses will be reduced to the extent of your business income, which means zero profit. You will be expected to return some of your income tax, including penalties and interest. And you will spend time in conflict with the IRS and paying for the services of an accountant instead of focusing on making a profit.

What to Do If You Are Audited

The initial thing to do is to ensure you carry out on your work as a freelancer in a businesslike manner. It involves keeping good records and maintaining a business diary that evident meeting with clients, projects, and deadlines.

You should possess business cards and a website that advances your business and keep a log of all gigs you apply for even if you don't land them. It will be more difficult for the IRS to show that you are just a hobbyist if you come to your audit equipped with a daily planner showing all these vital information.

Also, the hobby loss rule of thumb applies to one person business owners that file a Schedule C, so the surest ways to prove you are serious about doing business is to form a different business entity for tax purposes. You can choose from different business entities, each with having its tax structure.

C Corporations 

Regular corporations are also known as "C corps" to distinguish them from Subchapter S Corporations. C corporations possess their tax identification numbers, and they file their tax returns. If an organization has a loss, that loss is brought forward to pay off the next year's profits. Corporations can have many years of losses, and the accumulated losses can all move forward to pay off future benefits. 

S Corporations and Partnerships 

These businesses are not taxed at the corporate level. Profit or loss is transferred to its shareholders, and the shareholders report the profit or loss on their tax returns.

If you have a minimum of one other business partner, you can form a partnership, but an S corporation can be developed if you are the sole shareholder or owner. Both S corporations and partnerships report their dealings on a business tax return, and then they issue Forms K-1 to each shareholder to state the shareholder's portion of the profit or loss.

The IRS assumes that the shareholder works for the S-Corporation or partnership, so it expects that minimum part of the income by the shareholders will be taxable wages. You will be required to pay yourself a reasonable salary to prevent an audit, and you will have to pay tax on that salary even if the business is making no money.

Elliot Kravitz, ATP
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