When taxpayers have high W-2 earnings (in excess of $150,000 for example) coupled with large losses from self-employment activities, it’s like waving a big “Audit Me” sign! The IRS’ rationale for scrutinizing a tax return with these conditions is that if the taxpayer has substantial income unrelated to the self-employment activity, the taxpayer is more than likely to be operating the activity as a hobby and not as a business with a profit motive.
Hobby losses are only deductible to the extent of the income generated by the activity, while business losses are deductible to the extent the deductions are ordinary and necessary to carry on a trade or business. Having a business operating with a loss isn’t against the law, it’s just that you’ve got to be able to defend your loss and prove a profit-motive to the IRS. We’re going to delve into the details of what constitutes a profit motive, but first a questionnaire:
Can you answer the following questions about your small business in the affirmative?
- Is there a legitimate profit or gain motive?
- Are complete and accurate books and records maintained?
- Is there stationery, business cards, advertising or marketing?
- Does the taxpayer seek advice from qualified advisors?
- Does the taxpayer devote substantial time to the business activity?
- Has the taxpayer previously turned a similar unsuccessful business into a profitable one?
- Has the business activity previously generated significant profits?
- Do profit motives outweigh any elements of personal pleasure or recreation associated with the activity?
If you can answer most of those questions with a ‘yes,’ you’re in good shape and keep up the good work! If these questions have you shaking your head ‘no’ or scratching your head thinking “Books and records!?! Time dedicated to activity!?! Qualified advisors!?! Why are these things necessary for my business?” Well, we’re going to explain why these activities are crucial responsibilities for profitable business owners.
One of Don’s favorite Tax Court Cases, Zenzen v. Commissioner, gives a fantastic explanation of the roles and responsibilities required of business owners. The case describes how a taxpayer’s drag-racing business losses were denied by the IRS and how the IRS deemed the drag-racing business to be a hobby. The Tax Court agreed with the IRS finding that the taxpayer owed almost $26,000 in back federal taxes.
The taxpayer in Zenzen had no formal business plan, no annual budget, no expense forecasts and no formal records. The Tax Court held that the test for determining if a taxpayer is carrying on a business for profit is whether the taxpayer’s actual and honest objective in engaging in the activity is to make a profit. Furthermore, the taxpayer’s expectation of the profit does not need to accurate, but it must be a good-faith estimate.
The Tax Court and Internal Revenue Code conclude that it is the taxpayer’s responsibility to maintain books and written records. While this does not mean a sophisticated accounting system, a hodge podge of crumpled receipts is not going to cut it. Questions about books and records? Check out these tips: 1, 2, 3, & 4
Further, after years of losses, Zenzen never sought the advice of a qualified advisor to help him turn his business around. The Tax Court concluded that Zenzen really didn’t have a profit motive because he had taken no action to improve or to otherwise change his operating basis. Consulting with a competent advisor to help you establish and grow your business is a clear sign to the IRS that you’re focused on profit and growth.
The first few years of running a business can be extremely challenging and making a profit might not happen right away. A series of losses is NOT an indication that your business is not engaged for profit. However, the long term objective for your business needs to be to make a profit.
The findings in Zenzen provide a road map for the small sample of taxpayers with high W-2 earnings and let’s just go ahead and call them “Hobby Losses” that are reported as self-employment losses. If there’s truly no profit motive, then the activity is not a business. If you find yourself in this situation, the steps required to turn your hobby into a real business are outlined below.
Zenzen also provides a valuable take away for small business owners that find themselves making a living, but not truly profiting from their small business. The same steps required for converting your hobby loss into a real business, also apply to many small business owners. According to Zenzen, as a business owner you should:
- Maintain accurate books and records. Not just for your CPA, and not just for IRS but because it’s what profitable businesses do and it will help you run your business better;
- If you are not making sufficient profits, seek advice from qualified advisors to help you turn things around;
- If you’re not making the profits you expect, perhaps you are not devoting enough time to operate the business profitably; and
- Develop and follow a plan with the objective of realizing long-term profitability. Track your progress against the plan regularly and make adjustments as needed to ensure that you reach your financial goals.
Does this sound like something you need to do? If so, call us today to set up an appointment. We can help!