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We’re winding down on the factors the IRS will look at in determining if you’re engaged in hobby or a business.

The next one is:

History of Income or Losses

Now just because you have consecutive losses in the early years of your business does not mean the IRS is going to bring the hammer down on you.

Yes, the general ‘rule’ is losses that go on beyond a reasonable period necessary indicates that the ‘activity’ is not being run for profit.

BUT….

If the losses are explainable, such as business risks that are common to your industry, the ‘activity’ can still be considered as being conducted for profit.

Also, circumstances beyond your control do not dictate that your business is not run for profit.

Examples of these circumstances are:

-Drought

-Disease

-Fire

-Theft

-Weather damages

-Depressed market conditions

Here’s an example:

There was a case involving an attorney that started their own practice.  The attorney had substantial losses in the first couple of years.  Due to being a new attorney, she was reluctant to charge the full amount for services.

Add to that, the attorney had to provide care to her elderly dad during the years of getting the practice off the ground.

The IRS said the attorney was not intending to run a profitable business.

But the tax court said the IRS was WRONG.

The actions of the attorney showed a profit motive.

There were seven actions, listed by the tax court, that the attorney did do right. I won’t list all of them, but I’ll mention the two that I want you to remember:

1.  Conducting the activity LIKE OTHER solo practitioners and IN a BUSINESSLIKE manner.

2.  Keeping COMPLETE and ACCURATE business records. (That includes your FINANCIAL RECORDS).

(Plus the tax court said that losses during the first years of practice are expected.)

Again, the common theme of these factors the IRS looks at is if you’re keeping good business records.

And I’m sure that won’t be the last time I’ll say that!

Two of the tests the IRS will use to determine if your small business is a business or a hobby won’t pertain to the majority of small businesses that are being built from home.

But I said I’d talk about all of them, so here they are:

1.  Expectation That Assets Appreciate

This pertains mainly to the purchase of land that will be used in the business…for example a tree/timber farm. Art, antiques, and certain collectibles may fall into this category.  Always consult with your own tax preparer first.

No need to go further with this particular test.

2. Success In Carrying On Other Activites

If you had a similar business in the past that was unprofitable and then you made it profitable, the IRS may think you’re operating your current business to make a profit.

I can see this pertaining to those in direct sales.

Let’s say you sold AVON year’s ago before you had kids. You had a nice client base and made some decent income.  You gave up selling since you has twins, and it was a bit much to keep up with the twins and the business.

Now the kids are older and they’re in school.

So you have the time to service customers again and devote time to your business.

If you’re running some losses because you spend a lot on advertising and buying massive amounts of  brochures for exposure, it will look like you’re running your business to make a profit.

You’re following the same steps you did when you owned the same type of profitable business some years back.

At this point, if you’ve been keeping up with all these factors or tests, you should be seeing some kind of pattern:

PLANNING and ACTION.

And remember, the burden of proof  of your planning and action is on you.

I’m continuing on with what the IRS calls ‘factors’ to determine if your business IS a business or a hobby.

If your business shows a loss for more than 2 out of 5 years, the IRS may say your business is a hobby.

Read about that here.

In previous posts I talked about : (click on each to read that post and to get caught up)

Manner of Carrying on the Activity

Expertise of the Taxpayer or Advisers

So now the third factor is:

Time and Effort Expended In the Activity

Yes, it’s pretty straightforward.

If you devote  A LOT of your personal time and effort to conduct your business, you’re showing you have a profit motive.

And if you’re spending this time on a business that ‘does not have substantial personal or recreational aspects’, you’re showing A LOT of profit motive.

Let’s say you go on vacation every year someplace south where it’s warm, the waters are crystal blue, and some nice sea breezes are blowing.  While you’re at your annual vacation spot, you make a few bucks as a snorkel guide (is there such a thing?). So you get the brilliant idea: “Hey, let me write off my vacation as a business expense since I made a few bucks at the same time.”

That hobby ain’t gonna fly as a business with the IRS.

Now I know that may seem like a far fetched example, but it’s been tried before.

So let’s get serious again.

Did you leave your job to start your business?  Of course that shows a profit motive!

What if you hire other qualified people to work in your business, but YOU devote a limited time to the business? You can still show a profit motive.

And again, DOCUMENT what’s going on in your business…not after the fact, but as you go along.

If your small business is under IRS scrutiny, one of the nine factors or tests used will be the:

Expertise of the Taxpayer or Advisors

This means are you making an effort to learn about your industry and what practices your industry uses?

Or you using these practices you learned about in your business?

Are you learning and consulting with other experts in your industry?

If so, you’re showing you have a profit motive.

But if you’re buying a bunch of courses and don’t even implement what you’re learning, the IRS may say, “Just what are you doing?”.

So let’s say you’re a network marketer who wants to use the internet to get leads.  So you buy a course on how to build a blog, you buy a course on how to create super cool videos, and you spend more money on learning Facebook PPC.

But you never get your blog going, you don’t make very many videos, and you don’t even put one ad up on Facebook.

You’re NOT showing a profit motive.

It’s kind of logical when you think about it!

Also, if you’re consulting with a CPA, an attorney, or another professional in your line of business, makes notes of your meetings with them and document your implementation of their suggestions to improve your business.

If you don’t you may be showing you don’t have a profit motive.

Think about it…do you know how much revenue you need to bring even to break even or make a profit? Even a rough estimate? Is there any planning at all?

No?

You have no profit motive then.

I think this ‘test’ would be the biggest downfall for A LOT of small business owners.

But don’t panic.

This post serves two purposes:

1.  To really make you think about how you’re running your business and how much effort you’re really making in growing your business.

2.  To make you aware of what the IRS will be looking for in determining if your small business is a business or a hobby. These factors I’ve been talking about may not be the end all and be all.  No one factor carries more weight than another. Plus the IRS determination is not necessarily made by saying there are more tests showing no profit motive compared to the tests that show a profit motive.

So make a plan, document that plan, and document how you’re following through with that plan.

In the previous post, I talked about how the IRS may determine your small business is a hobby and not a small business.

You can read it here.

I also said I would prepare a post for each of the 9 factors the IRS may need to use to determine if your business IS a business.

OK here’s numero uno.

Formally know as:

Manner of Carrying On The Activity

Gosh does that sound formal!

But here’s what it means.

Your business must be carried on regularly and continuously. You need to show you have the intention of a having a long term business.

Are you conducting your business in a business like manner?

Are you maintaining  complete and accurate books and records?

The answer to those two questions had better be “YES”.  :)

When you’re conducting your small business in a way that is ‘substantially similar’ to other small businesses which are turning a profit, you’re proving to the IRS you have a profit motive.

Another way to show your business has a profit motive is to always be looking for ways to improve your profits such as:

-Changing operating methods

-Using new techniques

-Dropping what’s not working. Stop doing what’s not making you money.

You may have heard other people say to journal your business activity…document what you do everyday, future business plans, your marketing plan etc.

Not only is it good for seeing how much you’ve accomplished, it could actually help prove to the IRS your business IS a business.

You probably don’t want the IRS to even know you have a business, right?

Well, the IRS isn’t looking to shut your business down. It’s not the evil empire.

No, really it isn’t.

But the IRS does expect you to report your business income. Then you can deduct legitimate business expenses against that income so you have less taxable income.

It’s a fair deal.

If your small business makes a profit, the IRS will gladly take some more taxes from you.

If you pretty much break even, that’s OK too for the most part.

If you have a loss? A couple of loss years within 5 years won’t raise any IRS eyebrows.

But continuous losses?

This is where the IRS may say you DON’T have a business, and you are engaged in a HOBBY.

And it could come to the point where you’re going to have to prove that you have a real business.

So if you are a sole proprietorship, filing a Schedule C with your personal tax return, and your business is one of the following, you could end up under the IRS radar:

Airplane charter
Artist
Auto racing
Bowling
Craft sales
Direct Sales/Network Marketing
Dog breeding
Entertainer
Farming
Fishing
Gambling
Horse breeding
Horse racing
Motocross racing
Photography
Stamp collection
Writing
Yacht charter

I’m not saying the IRS will or will not question whether your small business is a hobby or not.

I want to make you aware that there is more scrutiny going on by the IRS.

So what happens if the IRS deems your business as a hobby?

Basically, you’ll still have to report the income from your activity, but the expenses allowed will be very limited.

However anything with the IRS is not always cut and dry.

The IRS is not gonna drop the hammer automatically and say your business is a hobby if you have more than two years of losses.

Remember up above I said you will have to prove your business is a real business?

There are 9 factors the IRS uses to determine if your business is really a business.

In subsequent posts, I’ll talk about each one of them.

Just today I received a fax from a client that really alarmed me.

It was a copy of an email from a scammer posing as the IRS claiming my client was eligible to
receive a TAX REFUND of a couple of hundred dollars and change.

I immediately knew it was bogus, but here is the SCARY part:

To ‘access’ the tax refund, a refund form which was attached to the email needed to be completed.

This form requested social security numbers, date of birth, address, and credit card information (YIKES!!!!)

And of course the form could be directly submitted online.

The WORST part is…

The client was THIS close to falling for it. They were just confirming with me it was OK to submit.

So close to disaster!

I’ve heard of this email going around, but this is the first time I’ve seen it.

I won’t tell you how to know it’s a legit email from the IRS or not because….

The IRS WILL NOT send you ANY tax correspondence via email.

If you receive something via email stating it’s from the IRS, do not open it, do not open any attachments,
and do not click on any links if opened in error.

FORWARD the email as is to: phishing@irs.gov.

If my client fell for it, I’m sure others will too.

So I needed to make you aware asap.

Are you avoiding critical home business training because you think it’s too expensive?

Listen to this audio about why you may be thinking about it the wrong way.

So why should you be thinking about your business taxes now?

Here’s why:

Halloween is over right? What happens after Halloween?

In no time flat the Holidays are here.

What comes right after the Holidays?  (This is not a trick question by the way.)

January!

What happens in January?

You start receiving those envelopes that say on the front in bold letters, “IMPORTANT TAX DOCUMENTATION ENCLOSED”.

You know what I’m talking about…interest and dividend statements, mortgage interest statements, W-2′s, and other stuff that may make your skin crawl just thinking about it.

So by the end of January, for the most part, you should have received all the ‘official’ documentation to get your taxes done.

Then you smack yourself on your head…your forehead to be exact!

Here it comes…

SMACK!

You just realized you have no idea what to about your small business.

All these questions are scrambling around in your head…

“Do I have to file business taxes?’

“How do I file them?”

“Did I make a profit and how much tax do I have to pay on that profit?”

“I don’t even have my business records together…what do I do?”

And maybe you’re feeling a little bit of panic set in.

This is why you need to think about your business taxes… NOW!

If you haven’t compiled your business income and expenses by now, you really need to start working on it.

You may already have a general idea in your head how you’re doing.

But if you know you’re doing really well, you may want to make it a priority to get those numbers together and have your tax preparer do a tax projection for you. That way, if it’s projected you’ll owe additional taxes due to your business, you can pay them in by January 15th and possibly avoid tax underpayment penalties.

Ok, so you may be saying ” Hrmpph…I’m just starting out, I didn’t make any money”.

Do you want to lose out on legitimate losses you may be able to take?  Do you really want to scramble at the last minute figuring all this stuff out?

Didn’t think so.

Even if you plan on taking your information to your tax preparer, you don’t want to wait until the last minute. Putting your tax preparer under the gun certainly doesn’t make him or her happy, plus there’s a higher chance for inaccurate return to be filed.