Q: I have a little multi-level home business selling cosmetics and household products. Every year I report a relatively small loss on my Form 1040, Schedule C. Is there a limit as to the number of years that I can report losses? Are there any issues I need to be aware of?
A: Generally, losses from your business will be deductible against your gross income. However, the Internal Revenue Service may take the position that your business is a “hobby” and not a “for-profit business.” This position would disallow all the losses you have previously deducted. The burden of proof is on you to prove that the business is really a business.
If you continually lose money, the IRS has a hard time determining whether you are truly running a business, or just treating a hobby as a business so that you can deduct your expenses on your tax return. If you don’t show a profit in three out of five consecutive tax years, the IRS may presume that your business is a hobby. The fact that the IRS “presumes” that your business is a hobby means that you have to prove them wrong and that you intend to make a profit. A special election on Form 5213 permits suspension of the presumption until there are five (or seven) years of existence from the time you first engage in the activity.
Some suggestions to help strengthen your case against the IRS for a “business treatment” as opposed to a “hobby treatment” are as follows:
· Your business should be conducted in a businesslike manner (business cards and literature, proper business tax licenses, business telephone book listings, etc.)
· Bookkeeping and accounting records should be in an acceptable form (preferably, you should maintain a separate business checking account and not commingle personal transactions).
· You should spend an appropriate amount of time and effort dedicated to your business.
· You should maintain a high degree of expertise relating to your business (attend continuing education or update seminars, etc.).
· Your business should reflect profit-making methods of operation (proper pricing and billing).
The above list is obviously more subjective than objective. However, if you are audited, the more you adhere to the above suggestions the better your argument will be with the IRS. If your business is really a hobby (or deemed to be by the IRS), you will only be able to deduct expenses up to the amount of income you earn from the activity.
Barry Dolowich is a certified public accountant and owner of a full-service accounting and tax practice with Monterey. He can be reached at 831-372-7200. Please address any questions to Barry at PO Box 710 Monterey, CA 93942 or email: firstname.lastname@example.org.