If you run a business with the intention to make a profit, you are allowed to deduct all expenses that are considered ordinary and necessary to operate the business. If expenses exceed income, the loss is deductible against other income, such as wages, interest, and dividends, etc. However, if the activity is not engaged in for profit, you cannot take the loss as a deduction against other income as the IRS views this as a hobby, rather than a business.
So, how do we determine whether the activity is for profit or not? The rule of thumb is that if the activity generates a profit for three or more out of five consecutive years, we usually presume that you are conducting the business with a profit motive. However, the IRS may still challenge you even if the activity has met the three out of five years test if the profits are small compared to substantial losses. Therefore, we need to look at various facts and circumstances to see if the activity is a business or a hobby.
- How you carry on the activity
- You and your advisor’s expertise as it pertains to the activity
- Time and effort spent by you in carrying on the activity
- The expectation that assets used may appreciate in value
- Your success in other similar or dissimilar activities
- Your history of income/loss concerning the activity
- Amount of occasional profits, if any
- Your financial status
- Elements of personal pleasure or recreation
There are a few strategies that you should consider that would support a for-profits business motive.
- Keep thorough and businesslike books
- Use a separate business checking account and credit card
- Record business and personal use of assets in a log book
- Research market/technology trends used in similar businesses
- Obtain insurance, registration, certification, proper license, etc.
- Document periodic evaluations of operations to attempt to improve a business’s profitability
- Develop a written business plan and update it annually
You would potentially have a tax bill once the business is profitable. Thus it is important to have a good tax advisor can help you to minimize tax bills through proactive tax advice and planning. If you have any questions, please contact the team today.