When starting a new business, an entrepreneur may be told that it could take three to five years to show a profit. While that may be true, it certainly isn’t something that the IRS will necessarily accept when it comes to filing a tax return.
At a recent Green Bay SCORE client meeting, Mary Guldan-Lindstrom, SCORE mentor and owner of FOCU$ CPA Inc., cautioned a client that business owners and the IRS might have differing views at what constitutes a business.
IRS Code Section 183, the “hobby loss rule,” limits deductions that can be claimed when an activity is not engaged in for profit. If your “business” does not show a profit for three of five years and you are audited, the result could be a challenge to determine whether it is actually a hobby rather than business.
How could the hobby laws affect you?
Guldan-Lindstrom says that could result in fewer allowed deductions, adjustments, exemptions and credits. While a business may deduct ordinary and necessary expenses in order to conduct that business or trade, an activity that is not entered into for profit will be limited to the income derived.
In other words, if business losses are being used to offset gains from other businesses or investment income, the IRS will not allow it under the hobby classification.
“The first thing I want to know when I see these losses is how real the numbers are,” Guldan-Lindstrom said. “They may be reporting expenses that aren’t true; numbers that don’t tell the story of the business. I want to know if they’re trying to make a profit or create a write-off. What are their intentions?”
She says that some people might want to use their “business” to fund a lifestyle. For example, a person loves to travel and therefore opens a travel agency so that travel expenses can be a write-off. There may be no intention to show a profit; the business is in place to help defer travel costs. If the IRS does an audit, those exemptions will likely vanish.
Other entrepreneurs may be unknowledgeable about the law, or have low expectations for success.
“You have to ask if the business is worth your time if you aren’t making a profit. I’ve talked to numerous business owners who have said they plan on losing money for five years. Don’t plan on that; especially if there is no big outcome at the end,” she said.
What can you do to help your business?
In working with clients who are showing losses, Guldan-Lindstrom will want to see how the business plans to make a profit. She will ask for a business plan that includes a sound business model. A loss might be valid, but clients need to be proactive and ready to defend losses.
She said, “Keep time documentation as to the work you’ve done for the business. Do you have subscriptions? Are you going to conferences, belonging to trade groups, or taking classes in your field? What are you doing to treat this as a business?”
The IRS will consider these and other factors that indicate if actions taken are indicative of a business. Among those are accurate record-keeping, the expertise of the owner, time and effort expended in carrying on the activity, the expectation of appreciation of assets, past experience with businesses, financial status of the taxpayer, history of income or losses, and whether or not the activity has elements of personal pleasure or recreation.
Guldan-Lindstrom recalled a client’s experience during an audit. “They had been working with another accountant, and not been warned about these rules,” she said. “When the IRS asked the wife if she enjoyed an aspect of her business, she said yes. The yes was a trigger, and the business lost its status.”
9:34 p.m. CST February 18, 2015
Tina Dettman-Bielefeldt is co-owner of DB Commercial Real Estate
in Green Bay and district director for SCORE, Wisconsin.
Reprinted from the Green Bay Press Gazette.