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Hobby Losses Legal Tax Angles: How to Save Taxes Without Going to Jail Most people seem to believe that they can’t deduct losses from a business unless they make a profit in three of every five years. That can be a costly misconception. The so called “hobby loss rule” is a win-win break for taxpayers. It came about because the law requires taxpayers to have a profit motive in order to deduct losses from business activities. Certain types of part time business activities were borderline as to whether there was a genuine profit motive or whether the activity was really a personal hobby. These borderline activities generated a great deal of litigation. After a while, the Congress added a provision to the law to eliminate a lot of the litigation. That provision (tax code section 183) gave taxpayers a safe harbor rule. The rule basically says that if an activity makes a profit in three years out of any consecutive five year period, it will be presumed to be a business in the other two years. Examples of borderline activities would include breeding cats, dogs or other animals, making arts and crafts for sale at craft shows, publishing a newsletter, participating in various kinds of home party selling where your main objective is to get discounts on the products, and other activities where your primary objective is personal satisfaction rather than economic gain. However, if you are engaged in an activity with an intent to make a profit, and if you are prepared to argue with the IRS in the event that they challenge you, then the law does not prohibit you from claiming deductions for losses every year without any restriction on the number of years such losses can be deducted. You do not have to forgo your loss deductions even if you don’t have a profit in three of every five years. But you do have to be able to convince the IRS or a judge (if you end up going to court) that your primary purpose for the activity is to make a profit. That profit doesn’t have to occur right away. Some businesses take many years to reach the point where they are able to show a profit. To demonstrate that your activity is profit motivated, you need to demonstrate that the activity is being operated in a business like manner and that you have a reasonable business plan that will lead to economic success. At a minimum, you should have a name for the business, some stationary, invoices, a separate bank account, separate books and records, a place in your home that is used only for this business activity and some records to show that you are spending some time working on this activity on a regular basis. A daily log or journal would be a substantial help in this regard. A formal business plan showing your projected income and expenses over a five or ten year period - with some profit at the end of the period - will be a huge advantage to you if you are questioned by the IRS. It would also help you to be able to show that you are actively studying and learning how to be financially successful in this activity. Attending seminars, subscribing to trade magazines or newsletters, buying (and reading) books about the business and consultation with various professionals will also help. Vern Jacobs Copyright, 2003 |
Books and Services by Vern Jacobs
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