home business

If your home business is turning up more losses than profits, you could find the spotlight of the IRS shining your way. You probably know that to pass muster with the Internal Revenue Service, your business is supposed to show a profit in three of five consecutive years. That’s called the hobby loss provision (Tax Code Section 183). The original intention of this rule was not to make your life miserable when your business is struggling, but to prevent wealthy individuals from lowering their overall taxes by deducting personal expenses on Schedule C. 

Schedule C Filing

In the past, the IRS has often turned a blind eye when Schedule C filers racked up four or more straight years of losses. After all, even tax authorities recognize that businesses face significant challenges. As long as there is reason to believe that the taxpayer had the objective of making a profit, the IRS has generally not pressed the issue.

That may all be changing soon. A recent report showed that in 2005 alone, individuals underpaid their taxes by $30 billion, by taking inappropriate deductions. Of that, $2.8 billion is estimated to be from hobbies, and about two-thirds of that underpayment is attributable to high-income taxpayers.

Under the existing hobby loss provision, the only way IRS officials can determine if a Schedule C filer is operating a legitimate business is to audit the full books and records of the taxpayer. There is currently talk of developing “bright-line” rules that make it easier for auditors to differentiate. Until then, the IRS is clamping down by taking a harder look at certain small businesses.

If you are a Schedule C filer, here are ten steps to take protect yourself, or risk having your business losses disallowed. These steps will help you demonstrate that you are operating in a businesslike manner. 

1. At a minimum, your business should have a business name, stationery, business cards, invoices, a separate bank account, separate records and books, and a separate place in your home dedicated to the business. 

2. Keep a daily log or journal of the time you spend working in your business. 

3. Be able to show that you are taking steps to improve your knowledge of your industry and general business success, such as reading trade journals and business books, and attending seminars that promote business tools. 

4. Advertise in appropriate places, and keep documentation of your ads. 

5. You should have a business plan that includes a cash flow projection for several years. This is a good idea regardless, because it estimates your income and expenses for every month so that you can see in advance when you are likely to need financing, and when you’ll have extra cash to plough back into the business. It also organizes your documentation if you need to apply for a loan. Templates for business plans are available at no charge by logging onto Score.org. 

6. Seek the help of a financial advisor or a professional in your industry. Check Score.org for free or affordable resources. Your local Chamber of Commerce may have a support system for small business.  

In addition, have these proofs available: 

7. Run monthly profit and loss statements. You may have only occasional profits, but sometimes that is enough to prove your intent.  

8. Retain documentation of uncontrollable circumstances that affect your profits, such as fires, burst water pipes inside your building, weather disasters, like Hurricane Katrina, or sudden death in your immediate family. Also keep copies of insurance reports, police reports, and even newspaper clippings with your tax records. 

9. If you have pursued similar activities in the past and earned a profit, have evidence ready, such as your tax returns for those years. That demonstrates that you do have what it takes to make the business work.  

10. If your business has purchased assets that are expected to appreciate, there is potential for future profit. The IRS generally accepts that as proof of the legitimacy of your company. You may need a professional appraisal.  

If the IRS suspects that your Schedule C activity is more of a hobby than a for-profit endeavor, they may come knocking at your door. By having ready evidence of your home business’s legitimacy, you can save yourself immeasurable grief. And there’s another, very practical benefit. Developing your evidence forces you to organize your business thinking and your documents, and in the process, you may discover ways to do things better that might turn your red ink into black. HBM 

Teresa Ambord is a former accountant, now a full-time business writer. Recent publishing credits include articles in Accounting Today and Technology Advisor, and e-books on Credit Repair and Identity Theft, available on her Website http://www.ambertrees.com