Do you know what your chance of being audited is? If you happen to be the President, it’s 100%. The returns of the President and his VP are required to be audited every year they occupy the White House. But what about for the rest of us regular Joes? If you’re not aspiring to lead this great nation of ours, your chances of being audited are less than 1%. So you can rest easy. There are, however, several red flags that can increase your chances of being the unlucky one selected for an audit. One of those is filing a Schedule C with your return. For those of you who have not memorized the many different IRS forms, Schedule C is what you use to report profit or loss from a business.
For those of you who haven’t memorized the many different IRS forms, Schedule C is what you use to report profit or loss from a business. If you earn money on the side as say a pet sitter or a blogger, Schedule C is what you would use to report your income as well as expenses you incur to generate that income. The IRS scrutinizes these returns a bit more closely.
If you have legitimate expenses and keep good records, then you should be fine. That is unless you try to deduct expenses greater than the income you earned. If you’re looking for a way to have a fun conversation with an IRS agent, you’ve just found a great way to do that.
Do I Have a Real Business?
Your true intentions when it comes to deciding if you have a real business may not matter. Let’s take Polly who wants to start a photography blog in her spare time. She registers the domain Polly Photography and hires a web designer to create her website for $500. Now if Polly is going to be a respected photography blogger, she can’t just go around taking pictures with her iPhone. So she goes out and buys a nice DSLR for $1,500. With her new camera in tow, she begins traveling around her city in search of good photo opportunities. Polly posts the pictures on her blogs and writes posts about her experiences and tips on how to take the best pictures.
Come year-end, Polly Photography has gained a little bit of traction, but not enough to cover her blogging expenses. In total, she earned $250 from advertising and affiliates on her blog. Polly dreams of one day quitting her job and running Polly Photography full time. But for now, it is just a dream.
So does Polly have a legitimate business? She’s making some money from her website and incurring expenses to get it up and running. Or is it just an expensive hobby? Unfortunately, like the tax code, the answer isn’t straight forward. Mixing business with pleasure never is.
Business or Pleasure: Why it Matters
There’s a good reason why this determination is important. If you have a true business, then all legitimate business expenses that have been incurred in the pursuit of generating a profit can be deducted. In Polly’s case, this would mean reporting income of $250, and expenses of $2,000 (new camera plus web design costs) for a net business loss of $1,750. This business loss can be used to offset her regular W-2 earnings.
But what if Polly’s business venture is considered to be nothing more than a hobby? Then she can only deduct expenses up to the amount of her income. Thus, Polly’s schedule C would show income of $250 and expenses of $250. Thereby resulting in no business loss being carried over to offset her W-2 earnings.
This small misunderstanding can greatly increase your chances of an audit. The IRS wants their money and doesn’t want to be taken advantage of. And you can bet the IRS will be paying close attention to your hobby business. This past year, the Treasury Inspector General for Tax Administration (who knew this was a thing?) announced the IRS needs to do a better job of policing this area.
How To Determine: Business or Hobby
Never fear. The IRS has issued a long and vague test to help determine if you are truly running a business or merely deducting your expensive hobby. There are nine factors that the IRS has come up with to consider. Making this further difficult, no one factor alone is decisive, leaving plenty of room for interpretation.
Full Disclosure. This subject can become very complex. I am not a tax code expert. Consult a tax expert for guidance on your specific situation.
Nine Tests the IRS Considers:
1) You carry on the activity in a businesslike manner.
2) The time and effort you put into the activity indicate you intend to make it profitable.
3) You depend on the income for your livelihood.
4) Your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
5) You change your methods of operation in an attempt to improve profitability.
6) You (or your advisors) have the knowledge needed to carry on the activity as a successful business.
7) You were successful in making a profit in similar activities in the past.
8) The activity makes a profit in some years.
9) You can expect to make a future profit from the appreciation of the assets used in the activity.
Clear as mud? Here are my takeaways. Again, this is just my opinion and should not be considered professional advice. I am not, and have never been, a practicing tax accountant.
In the case of Polly, I believe her case is pretty cut and dry. Or at least as much as one could be. She has yet to show the ability to make a reliable income that will make her profitable in future years. Polly has no experience running a profitable blog and does not have the knowledge needed to turn the blog into a successful business. At least yet. She has another job and does not depend on the money from Polly Photography, which is a good thing for her because she isn’t making any.
Unfortunately for Polly, this is just an expensive hobby. At least for now.
Improve Your Case
The number one thing you can help your case of running a true business is to keep good records. Comprehensive and detailed records or your income and expenses is a great start. Tracking the amount of time you spend on your pursuit is also worthwhile. If you spend 20 hours a week on your venture, you’ll have a lot easier time convincing the IRS it is a true business than if you just spend a few hours here and there.
Making a profit will always be your best case, though. Let’s say you start a blog. In year 1 you incur start-up expenses and spend your time creating content and finding an audience. As a result, you lose money. In year 2 your hard work pays off and you turn a small profit. Then in year 3 you hit a rut and don’t make any money. By only turning a small profit in 1 of 3 years, you’ll have a hard time convincing the IRS you have a real business. In general, the IRS presumes an activity is carried on for profit if it made money in 3 of the past 5 years. This rule isn’t carved in stone, but if you don’t otherwise have a strong case, it will be a tough one to overcome.
Hopefully everyone reading this is making mad amounts of money through their side ventures and don’t have to worry. But if you did incur a loss, think twice about deducting excess expenses on your taxes.
Readers, have you filed your taxes yet? If you have a business venture on the side that lost money, how did you elect to file your taxes? Did you seek the help of a professional or did you DIY?