Business is never a sure thing. Many experience losses before gaining success. If you are operating a home-based business and are experiencing tax losses, it is best if you check out the IRS rules on the deduction of tax losses. There is a cap to deducting ordinary losses from a business. But there is a rule from the IRS that the business owner must first indicate a profit for three years out of five (3 out of 5 rule) in order for the losses to be allowed to be deducted.
3 OUT OF 5 RULE
A lot of taxpayers are aware of this 3 out of 5 rule. Some actually believe that as long as you can present a profit for 3 years out of the 5 consecutive years, then everything will be good. Then there are those who think that if they fail this 3 out of 5 rule then losses aren’t deductible. First, getting the 3 of 5 rule only means that the business has made a profit. There is no distinct indicator that when you experience losses of 4 years in a row that you are not eligible for deduction. This only means that losses will be subject to further assessment through an IRS Audit. There is a possibility that the IRS can reconsider the deduction if you meet the criteria for broader exceptions to the 3 out of 5 rule.
Second, just because you did not meet the 3 out of 5 rule, it doesn’t mean that you cannot take advantage of the IRS tax deductions. It only means that you have a steeper climb in order to show that you had a profit motive. What follows is a 9-Factor Test.
Factors Considered
The 9-Factor Test enumerates nine factors that should be evaluated in a business to determine if it was indeed engaged in making a profit. The IRS and the courts will make an assessment of these factors. The facts and circumstances of the business activity will have to be taken into consideration. There is no one factor that can determine profit motive. You also have to take into consideration that while there are nine factors indicated, it doesn’t mean that the government is limited to checking out those nine items. It also doesn’t mean that a determination can be made based on the number of factors indicating a lack of profit objective. This means that the IRS and the courts can make a determination on any of the factors and weigh them. Take for example: the court looks at nine factors and six of those back you up while three are on the IRS’ side. While it may seem that the odds are in your favor, the court can still rule that one of the three factors from the IRS is much heavier than the six from the business side. The court may still rule for the IRS. Among the factors that are looked into are:
THE 9-FACTOR STANDARDS
1.MANNER IN WHICH THE TAXPAYER CARRIES ON THE ACTIVITY.
When the business owner or taxpayer proceeds with the activity in a business-like manner and regularly updates books and records, it indicates a person’s seriousness in making a profit for the business. As long as the business has activities that point to making a profit as other money-making businesses do, then that’s a score for the taxpayer. Things that indicate profit motive include changing methods of operation, adoption of new techniques, abandonment of unprofitable methods, which is indicative of the intent to improve profitability.
However, a lot of taxpayers are not in the habit of keeping regular or accurate books and records. Without such documents, there is no way of knowing how the business is doing; hence, the business owner cannot improve profitability. Based on records, having a good record-keeping ability will impress the court. The records are always cited by the courts, hence these are important considerations.
Another critical aspect is when you continually modify the business plan for profitability’s sake.
2.THE EXPERTISE OF THE TAXPAYER OR HIS ADVISORS.
When the business owner / taxpayer consults with experts about business activities, it usually means that he or she is serious about making a profit. Among the factors that indicate serious preparation for profit motive in a business include extensive study, economic and scientific practices and consultation with the experts. But it is also possible that the business owner has implemented all these but the activities in the business are not in accordance with profit motive. These preparations should also be coupled with intent to make a profit in order to look good with the courts.
The court is also fond of looking at the expertise of the taxpayer. For instance, a person who has an extensive repertoire in retailing operations will have a good chance at succeeding selling on the web. The court usually looks into those things. In one case, the court awarded this factor to a taxpayer with a farming business, who was not actually a farmer—nor was the spouse. However, the business owner and the spouse were both raised in a farm, which counts in the expertise department. On the other hand, if you don’t have any expertise in the field but get experts in your side by consulting a CPA, marketing professional or engineer, then you have done something good in the name of profit motive. You need more experts on your side if your business is too far apart from your profession.
3.THE TIME AND EFFORT EXPENDED BY THE TAXPAYER IN CARRYING ON THE ACTIVITY.
Another thing that indicates seriousness in gaining a profit is when a taxpayer goes out of his way to make an effort to do an activity on his own personal time for the good of the company. Points for the taxpayer if the activity does not have any personal or recreational aspects, which means the activity is purely for profit motive. Another proof of profit motive is when the taxpayer disengages from his occupation in order to dedicate a lot of time and effort in the business at hand. But when the taxpayer does the opposite—spends a limited time on the business—it doesn’t mean a lack of profit motive as long as the business employs competent and skilled people to carry on the activity.
Just a casual interest in the business is not going to look good for the courts. If you start a farm just because you want to get away from the city will only mean you’re not getting a point under this factor. Make sure you log your activities because it can be very helpful when the court wants to track down the activities you spent in order to make a business profitable. You don’t necessarily have to spend all your time in the business, but working for its profitability for a good amount of time will make you look good in the courts.
4.EXPECTATION THAT ASSETS USED IN ACTIVITY MAY APPRECIATE IN VALUE.
The term “profit” includes the appreciation of the assets used in the activity like land or buildings. So it may happen that while the actual business is not making a profit, after the consideration of the appreciation of the value of the land and the building, the summation actually locks in a profit.
Here’s a case: You get a land in the suburbs and start your own small amusement park. Along the way you realize that it’s hard to make a profit off an amusement park. But then you realize that the value of the land where the amusement park is on is appreciating rapidly. This will then result in a profit. But here’s a caution: a different set of rules apply when operating a farm.
5. THE SUCCESS OF THE TAXPAYER IN CARRYING ON OTHER SIMILAR OR DISSIMILAR ACTIVITIES.
A person’s business history will play an important role in this test. The fact that he successfully converted an unprofitable business to a profitable one in the past may mean that he’s in the present activity to make a profit. This, even though the current business is not making a profit. Serial entrepreneurship does exist. As long as most of the lined up business were a success, then this is a good argument for you to use.
6. THE TAXPAYER’S HISTORY OF INCOME OR LOSSES WITH RESPECT TO THE ACTIVITY.
If a person has been engaged in several businesses that have not made profits, it’s not necessarily the end of the world. It sounds bad but this can’t solely mean that the taxpayer is not in the current business for profit. This negative serial entrepreneurship can only be considered bad when losses are sustained without proper explanation.
There are other explanations to sustained losses and some of them are acceptable by the courts. The acceptable reasons are extenuating circumstances that are beyond a person’s control. Among them are depressed market conditions, disease, drought, fire, theft, weather damage and other involuntary conversions. These circumstances do not indicate that the business does not exist for profit. But there has to be a record of a series of years where net income was realized.
When it comes to startups, the courts are usually looser when evaluating its activities. Courts look at common service business like lawn maintenance and tutoring don’t take too long to become profitable.
Meanwhile, a manufacturing business with a large capital investment on heavy equipment and rent will naturally take longer to make a profit. Under the unique situations are artists, writers and musicians. These people usually take years before they make a profit.
7. THE AMOUNT OF OCCASIONAL PROFITS, IF ANY, WHICH ARE EARNED.
The courts also look at the amount of profits vis a vis the amount of loss in relation to the investment made by the business owner and the value of the assets used in the business. Going into this formula, the courts will be able to determine if there is an intent to profit. Getting an occasional small profit while activities generate large losses usually means that business is not for a profit. Either that or when the taxpayer makes large investment and only minimal profit. But substantial profit, no matter how sporadic it is, may mean profit motive where the investment or loss is kept at minimum. Also, when there is an opportunity to earn a substantial profit in a highly speculative venture, it is sometimes enough to indicate that the business is there for profit.
8. THE FINANCIAL STATUS OF THE TAXPAYER.
If the owner or taxpayer doesn’t have any other means of income except for the business then it usually means that it is engaged for profit. But if there are other sources of income, especially when losses from such other sources generate substantial tax benefits, it usually means that the business is not for profit—especially if recreational pleasures are involved.
9.ELEMENTS OF PERSONAL PLEASURE OR RECREATION.
When there is a personal motive involved—when the business is only a front for recreational or personal elements—then it usually is indicative that it doesn’t have profit motive. However, when the business doesn’t have a lot of personal appeal save for profit, then it is so much easier for the courts to believe that the activity is really for profit. However, it doesn’t mean that the business is solely intended to maximize profits. For instance, if there are other investments that yield more profit than the activity at hand, it doesn’t’ mean that the business is not engaged in profit-making. On the other hand, it doesn’t mean that just because some kind of pleasure can be derived in the activity, doesn’t mean that it is not for profit. But there should be other factors that indicate that the business is indeed for profit.
However, there are always some exceptions to the rules. In the case of artists and writers, the courts usually don’t give much weight to factors 8 and 9, as well as 1, 2 and 3.
Other Points
Enjoying the activity is not always a critical factor. But it can be the tip-off. Say you have listed auto racing, yacht chartering, modelling, antique dealer, etc as the specific business on a Schedule C. These could be questionable. The red flag is more visible when there is substantial income from other sources.
Most taxpayers believe that the hobby loss rules (code section: “Activities Not Engaged in for Profit”) only apply to sole proprietorship—this is not true. It applies to any form of business: S corporations, LLCs, partnerships, trusts, etc. Only regular (C) corporations have immunity. The rules may be the same for rental properties just like when renting a second home.
In the case of rental properties, you may be confronted with the hobby loss rules if you rent out a property to a relative for an amount lower than what’s fair in the market. That’s the most common argument used by the IRS in similar situations. Still, renting the property for less than the fair market value to non-relatives may cause the same kind of problems.
The guidelines are also applicable by activity. You cannot combine two activities—one cannot offset the other. If one business is losing and the other is earning, you cannot combine the two activities to balance the income. For instance, there is an S corporation that rents out heavy construction equipment—this business regular turns out a profit. Then you place your 60-foot sailboat used for chartering in the S corporation—but this business is regularly experiencing losses. So the S corporation is making a profit. But the IRS can simply say that the yacht charter is not engaged in any profit so the losses will be disallowed. However, if the S corporation’s primary business was as a marina, shipyard or a similar activity, then the IRS may consider combining yacht chartering with the other activity.
The rules were made so as not to disallow deductions for expenses. These are essential, though, when you sell an asset for a loss that has been used to keep business at bay. Losses from the sale of a business property (vehicles, equipment) can take a full deduction. Losses on non-business assets may or may not be deducted as capital loss.
When the IRS or courts denounce the activity as for profit, it doesn’t mean that you lose all deductions. The deductions will be disallowed based on a three-step approach. Expenditures that can be subtracted despite the business activity (taxes, interest) will be deducted first. Next, expenses that would be deductible if the activity was engaged in for profit, if such will not result in an adjustment to basis (depreciation, worthless debts, amortization and only up to the gross income from the activity. Third, amounts reaching adjustment to basis, but only until the remaining income from the business.
When you pass the hobby loss test, there are still rules to follow: the passive activity rules. You have to indicate that you actively participated in the business. This is critical if you are more of an investor in the company. For instance, you are the capital behind your daughter’s professional motorcycle racing activities. You may say that you have been reviewing the books and have been offering some advice. But these cannot be considered active participation. Your involvement should be bigger than that—you may work as a manager or salesman, etc. The next step will determine how much time you spent in the activity.
But if the business is a one-man show, then you may have met the requirements. That is if your participation was essentially all the participation in the business of all persons for the tax year, including the attendance of persons who did not invest in the business or you participated in the business for over 100 hours in the tax year, and you were involved at least as much as another person (including individuals who did not own any interest in the activity) for the year. If you believe you are in such situation then you should log your time in a journal.
