Apparently the IRS is focusing on small businesses that have reported losses in 3 or more consecutive years. Letters have gone out for the 2017 tax year advising some taxpayers that their business is being reviewed to determine if their ‘business’ is actually a hobby. The letter advises that 3 years of returns will be reviewed.
Worst case? If your business is determined to be a hobby, then any expenses exceeding income will be considered non-deductible. This can result in thousands or tens of thousands of dollars in assessed penalties, interest and taxes.
It is our understanding that businesses that have shown losses for 3 consecutive years are being reviewed.
So, how does the IRS determine if you are a hobby or a business? This is a facts and circumstances test and many factors are considered in the determination.
- Is activity carried on in a businesslike manner and are complete records and books maintained.
- Does the time and effort put into the business indicate you intend to make it profitable?
- Do you depend on the business income for your livelihood?
- Are losses beyond your control or are they normal in the startup phase of your business?
- Have you changed your methods of operation to attempt to improve profitability?
- Do you have the expertise or knowledge needed to carry on the activity as a successful business (or have you sought that knowledge)?
- Have you been successful in similar business activities in the past?
- Whether the business makes a profit in some years and how much?
- Whether you expect to make a future profit from the appreciation of assets used in the activity?
If you have several years business losses, there are things you can do that might help if you are audited.
- You should have a business checking account.
- Your records should be legible and complete for each business year (go back 3 years).
- Show that you have taken steps to improve your business knowledge, i.e., hired a coach, taken classes, purchased books, etc.
- Try and recreate logs showing how much time you put into the business.
As an example of what could happen if your business losses are denied, let’s assume you pay about 30% in Federal and state taxes combined and you have shown losses totaling $25,000 in the last 3 years. The new tax assessment alone would be over $8000. On top of that, you would owe interest and penalties going back 3 years. Lets say that adds on another $3-$5,000. If there is a ‘substantial underpayment” in any year, where tax is underreported by 10% or more, the tax assessment alone can be increased by 20%. If your records are so bad that the IRS considers your tax filing to be fraudulent, the tax bill can be increased by 75% plus penalties and interest.
If you think you could be one that receives one of these letters, now is the time to make sure your records are in order. Once you receive the letter, you typically have 30 days or less to respond.