If the IRS determines that your business or investment activity is not conducted as a for-profit business, IRS Section 183 limits deductions to the amount of income from the activity. They will classify your activity as a hobby, and unlike a business, hobby losses can’t be applied against other income and can’t be carried over to future years.
That means those business deductions you’ve enjoyed, perhaps for years, will no longer be allowed.
Here are a couple of examples of ‘businesses’ that have been reclassified as hobbies (according to the IRS).
Say you’re in an MLM activity. You use the products and enjoy the discounts you receive on those products by being a distributor to your friends, family and neighbors of those same products. You enjoy going to the conventions, especially those in cities like Las Vegas or Orlando and you’ve been taking a lot of deductions on your taxes including the convention expenses, because you don’t have enough sales to cover the expenses claimed. This reduces the amount of other taxable income and reduces your tax bill.
Or maybe you’re good with your hands. You build things or sew things and make a little money selling the items from time to time but again, profitable years have been limited or non-existent.
If the IRS audits you and decides your business is a hobby, any deductions claimed during the year of years of audit will be disallowed and taxes, along with penalties and interest, will be assessed.
If you want to avoid this, and I’ll be blunt here, you need to either start treating your activity like a business or quit claiming the activity deductions on your tax return.. You can start today in making the changes needed if you wish.
The IRS looks at 9 areas to determine if an activity is actually a business. This is a brief description but should provide a feel for how the IRS makes such determinations.
• Manner in which taxpayer carries on the activity . Is the activity conducted in a business like manner with accurate books and records kept. Is there a profit motive?
Does the taxpayer have expertise in business activity? If not, have advisors been retained, is education being sought?o Does taxpayer have knowledgeable advisors?
• Is time and effort expended by taxpayer sufficient to generate a profit? Is time spent in activity sufficient to improve or create profits?
• Is there an expectation that assets used in the activity may appreciate in value, such as land? Will the expected increase in value exceed costs of operation, such as improving raw land or flipping houses?
• Does the taxpayer have a history in carrying on other similar or dissimilar activities?
• What is the history of taxpayer profits and losses in the activity? If profits are intermittent or losses are continuous, are there valid reasons for such?
• Are there occasional large profits which exceed losses over time? This could indicate the activity is carried on for profit.
• Are there other sources of income or capital from other sources. If not, that may indicate that the activity is meant to bring a profit. Or, if other income is present, are losses generated to produce a tax benefit?
• Are there elements of personal pleasure or recreation in the activity?
If you feel that your activity would be vulnerable if looked at by the IRS, you should look at each of these points and ask what could be done to strengthen your position.
Here are some examples of how to improve the look of the activity:
• No records? That’s obvious. You need a bookkeeping system that is kept up to date. You should have records of expenditures and receipts. There should be a chart of accounts, etc. etc.
• Lacking in some aspect of knowledge needed to run or improve your business? Are you seeking the knowledge needed? You could take classes, hire advisors, attend seminars, etc to show that you are serious about your business.
• A history of losses? Keep records as to what impacted your business and what is being done to remove or lessen those impacts.
If you think you might fare poorly in an IRS hobby audit, give AFS a call. In a short consultation, we can recommend actions needed to show the IRS that you have a profit motive and reduce or eliminate the chance that your activity is determined to be a hobby.