How IRS Hobby Loss Audit Works

How IRS Hobby Loss Audit Works

Business losses reduce taxable income and many good freelance businesses incur losses which is somewhat a good thing since it means you pay less in taxes. A business loss could mean that you receive a bigger refund if you also have a day job for which you’re paid as an employee on Form W-2 compared to someone who earned the same amount of wages but did not have a freelance gig side business. 

It is an excellent tax strategy if you reduce your taxes this way. In fact, for people with high incomes to have a loss, many tax professionals encourage them to convert their hobbies into “businesses”. The Internal Revenue Service caught on this strategy unsurprisingly. 

Rule of Thumb in the Hobby Loss

In distinguishing between a hobby and a real business based on a tax return, there’s no hard-and-fast method. Without using the general rule of thumb, there’s no way to tell a legitimate business from a hobby. The IRS presumes that it’s a for-profit business if a business reports a net profit in at least three out of five years. It is also presumed to be a not-for-profit hobby if a business reports a net loss in more than two out of five years.

On young businesses, this rule places a huge burden of proof. New businesses will incur a loss is what the IRS expects on the one hand. It’s normal for business before becoming profitable to have a year or two of losses. On the other hand, it’s likely that business before making a profit could have several years of losses.

Factors that Contribute

You might still be able to prove your profit motive based on nine other factors if you can’t meet the three-out-of-five-year rule:

  • In a business-like manner, you should carry on the activity.
  • An indication that you intend to make the activity profitable is the time and effort you put into the activity. 
  • You are depending on your livelihood from the income of the activity. 
  • Your losses are considered normal in the start-up phase of your particular type of business or they’re due to circumstances beyond your control. 
  • In an attempt to improve profitability, you change your methods of operation. 
  • As a successful business, you and your advisors have the necessary knowledge to carry on the activity. 
  • With similar activities in the past, you were successful in making a profit. 
  • The IRS will consider how much of a profit it makes if the activity makes a profit in some years.
  • From the appreciation of the assets used in the activity, you can expect to make a future profit. 

If you are audited, what will happen?

Defending your business losses through auditing can be time-consuming and expensive. The IRS will disallow your business loss of you lose. This means you will have zero profits since your business expenses will be limited to the extent of your business income. You will have to repay some of your income tax, plus penalties and interest. And instead of focusing on making money, you will have to spend time-fighting the IRS and paying an account. 

What should you do if you are audited?

In a very business-like manner, you should carry on your freelance work. This means keeping a business diary that contains meetings with clients, deadlines and projects. You should keep a log of freelance gigs you apply for even you don’t land them and you should also have business cards that promote your business. If you arrive armed with a daily planner showing all this information, then it will be harder for the IRS to prove that you’re just a hobbyist. 

Sole proprietors who file Schedule C is where the hobby loss rule of thumb applies to. To prove you are serious about doing business and not just engaging in a hobby and writing off your expenses, there is no surest way to do so but to form a separate entity for tax purposes. Each with its own tax structure, you can choose from several varieties of business entities. 

C Corporations

Subchapter S Corporations or S corps are different from regular corporations or sometimes called C corps. C corporations file their own tax returns and have their own tax identification number. The loss that the corporation will have carries forward to offset the next year’s profit. The accumulated losses that corporations will have for several years will be carried forward to offset future profits. 

Partnerships and S Corporations

“Pass-through entities” is another name of this. At the corporate level, these businesses aren’t taxed. On shareholder’s personal tax returns, they will report the profit or loss since any profit or loss will be passed through them. An S corp can be formed if you’re the only shareholder or oner but if you have at least one other business partner then you can form a partnership. On a business tax return, both partnerships and S-Scorp report their profits or losses and use Form K-1 to each shareholder for their share of the profit or loss. 

In order to avoid an audit, you have to pay yourself a reasonable salary. Your second shareholder could be your spouse, significant other, or any other person if you elect to form a partnership. You can retain the control of 99 percent while your partner could own as little as 1 percent since it doesn’t have to be 50-50 ownership arrangement. 

Business Entity as a Loss Strategy

Consider forming a separate business that will protect your losses if you have already used up your two years’ of losses. Even if you ultimately succeed in defending yourself, you should take into account the added cost of potential IRS audit plus the added cost of incorporating in your home state.

 Since current losses will reduce future profits, might as well consider forming a C corporation if your business activity is expected to be profitable over the long-term. The three-out-of-five rule does not apply to C corporations according to the IRS. 

Consider forming a partnership or an S corporation if you expect that your business activity will continue to generate losses for the foreseeable future. If there are any future losses will not be reduced by previous losses but current losses will reduce current income on your 1040.

A middle ground between Schedule C sole proprietorships and regular C corporations is what S corporations-- or a partnership if you can find an additional shareholder will offer. An effect of increasing losses and minimizing profits is what paying yourself a salary in an S corp even if sound like a disadvantage. 

After weighing the important factors such as your other income, your marginal tax bracket, expectations of future profits, and your personal tolerance for record-keeping and dealing with the IRS-- then you can make your personal decisions. Remaining a Schedule C sole proprietor means you have a greater chance of being audited and incorporating requires more paperwork. 

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