Very frequently tax preparers are asked to provide clarification on IRS rules that they heard from a friend, neighbor or colleague. Usually some part of the statement is true; however, there is always more to the story or it may not apply to that person’s specific situation. If you’ve heard the statement, “You can’t deduct a loss from business if it occurs more than three out of five years,” this is not the entire truth.
Guidelines
A person that conducts an activity for profit is allowed to deduct the expenses that are ordinary and necessary in that industry. If the expenses exceed the income, the amount can offset other income such as wages, interest, or dividends. However, if your activity is a hobby, you cannot reduce your other income by the losses.
When your losses exceed the three-year rule, the burden of proof now shifts to the taxpayer to prove the activity is a for-profit business. Here are some factors to consider:
• The manner that you carry on the activity and the expertise of the taxpayer in this industry
• The time and effort spent in the activity
• The taxpayer’s history and success in this industry
• The elements of personal pleasure or recreation
Here are some ways to ensure your for-profit business is not considered as a hobby:
1. Keep thorough and professional books.
2. Use a separate business bank and credit card account(s).
3. Log any personal use on assets, such as a camera.
4. Research trends in similar businesses.
5. Obtain insurance, registrations, certifications, licenses needed for that type of industry.
6. Maintain a second phone listing for business.
7. Document evaluations of your operation to attempt to improve the business’s profitability.
8. Develop a written business plan and update it annually.
9. Keep a detailed calendar of your business activities.
Here’s an example: Joe had a business as a personal chef. This was not his primary way of earning income. He had a W-2 job with a local city. He did earn about $200 to 300 in income; however, his expenses were much more than that. Come to find out, he was hosting dinner parties at his home and wanting to write off the food, subscription to cooking magazines, and seeds for his home garden.
If you are in doubt, just imagine yourself in front of an auditor explaining your specific situation. If it “feels” like the story above, it may not fly with the auditor, but that does not mean it is not a true business. What you need to do is plan and strategize. What can you do today to prove that you are a for-profit business?
Know the rules and then step out in confidence. And, don’t get tax advice from a friend because it might not be the whole truth! Consult your tax preparer to confirm your specific situation qualifies.