There is a presumption that an activity is engaged in for profit if the activity is profitable for three years of a consecutive five-year period. If you show prolonged business losses, in consecutive years, you run into the risk of drawing IRS’ attention.
Now if you open a business and you show losses for a couple of consecutive years, in the initial startup phase that is normal, but of course you should document your efforts in making your new business profitable and you should maintain complete and accurate books and records. This is really important because otherwise you run into the risk of the IRS reclassifying your business activity to be a hobby.
Hobby activities have a very disfavorable tax treatment. Any expenses allowed cannot be more than the income from the hobby activity and for tax years 2018 through 2025, you pay tax on the hobby gross income without being allowed to reduce that income by your associated expenses, except for the cost of goods sold.
Factors In Determining If Your Activity Is For Profit
There are various factors in determining if your activity is for profit or not, but let me give you some examples of these factors:
- Is your activity conducted like a business?
- Do you maintain complete and accurate books and records?
- Do you do the activity in the same way as similar profitable activities?
- Do you change your methods of operation to improve profitability?
- Do you advertise or promote the activity?
- What is your expertise in the activity?
- Is the activity a main source of income for you?
- Does the activity have elements of personal pleasure or recreation?
- Do you spend much of your personal time and effort on the activity, particularly if the activity does not have personal or recreational aspects?
- Have you pursued the activity full-time or part-time?
- Have you made or expect to make a profit?
- Do any losses from the activity fall beyond your control?
- Do your losses continue beyond the period which would be necessary to bring your activity into profitable status?
Some of these factors came into play for an ER doctor. He got into trouble with the IRS due to the hobby lost rules, among other things. You can see his story by clicking on the link below:
https://youtu.be/yH2dX-Wqc6Q
Tax regulations can be complicated. That is why, it is very important when you have a business to seek professional advice.
If you are in need of a good CPA firm contact us!
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This material is for informational purposes only. It does not constitute tax, legal or accounting advice.