Q: I have a little multi-level home business that sells cosmetics and homewares. Each year I report relatively small losses on Form 1040 Schedule C. Is there a limit to the number of years I can report losses? Is there anything I need to be aware of?
A: Generally, your business losses can be deducted from your gross income. However, the IRS may consider your business a “hobby” rather than a “for-profit business.” This location will not allow all losses you have previously deducted. The burden of proof is on you to prove that the business is indeed a business.
If you keep losing money, the IRS will have a hard time determining whether you’re actually running a business or just treating a hobby as a business so you can deduct your expenses on your tax return. If you show no profits in three of five consecutive tax years, the IRS may assume your business is a hobby. The fact that the IRS “assumes” your business is a hobby means you have to prove them wrong and that you intend to make a profit. A special election on Form 5213 allows presumption to be suspended until five (or seven) years after your first participation in the activity.
Some suggestions to help you strengthen your case against the IRS for “business treatment” rather than “hobby treatment” include the following:
· Your business should be conducted in a pragmatic manner (business cards and literature, proper business tax licenses, business phone book listings, etc.)
· Bookkeeping and accounting records should be in an acceptable form (preferably you should keep a separate business checking account instead of mixing personal transactions).
· You should devote an appropriate amount of time and energy to your business.
· You should maintain a high degree of expertise related to your business (attend continuing education or refresher workshops, etc.).
· Your business should reflect a profitable way of doing business (appropriate pricing and billing).
The list above is obviously more subjective than objective. However, if you are audited, the more you adhere to the above recommendations, the better your argument with the IRS will be. If your business is truly a hobby (or considered by the IRS to be), you will only be able to deduct expenses for 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 in Monterey. He can be reached at 831-372-7200. Please direct any questions to Barry at PO Box 710 Monterey, CA 93942 or email: bdolowich@gmail.com.