Businesses that generate consistent losses are an audit flag to the IRS. Under Internal Revenue Code Section 183, if an activity isn’t engaged in for profit, the deductions for the activity are generally limited to the amount of income from the activity. The nickname for this rule is the “hobby loss” rule, but it isn’t limited to hobbies.
The IRS has issued an audit guide on this issue that is a very helpful reference. Here is a link to the guide. http://www.irs.gov/businesses/small/article/0,,id=208400,00.html. Also see Publication 535, page 5. http://www.irs.gov/pub/irs-pdf/p535.pdf.
If an activity is found not to be for profit, the income is not to be reported as business income on Schedule C, but as other income. Since the deductions are not considered to be from a trade or business, they are reported on Schedule A. Mortgage interest for a home office would be reported as mortgage interest. Property taxes are reported as a deduction for taxes. Most other deductions are reported as miscellaneous itemized deductions.
Since deductions for taxes and miscellaneous itemized deductions are added back to taxable income on the alternative minimum tax form, Form 6251, having an activity classified as not conducted for profit can not only result in having deductions disallowed for the regular tax, but can result in an additional alternative minimum tax liability.
The limitation on deductions for activities not engaged in for profit applies for individual income tax returns, S corporations, partnerships and trusts (any pass-through activity that can flow to an individual income tax return.)
An activity is presumed to be conducted for a profit if it generates a net profit for three or more tax years of five consecutive years, or two or more of seven consecutive years for horse racing, breeding, training or showing. This presumption can be overcome by the IRS. Taxpayers elect to postpone the determination of a profit motive by including Form 5213 within three years after the due date, determined without extensions of time to file, of their income tax return. The taxpayer agrees to extend the statute of limitations when he or she makes the election.
Real estate activities that generate losses generally can still be considered to be activities conducted for a profit, because the expectation of appreciation in value is a factor that indicates an expectation of a profit. Some vacation home rentals have been found to be activities not conducted for a profit when they weren’t operated in a businesslike fashion.
There is an order of allowed deductions for activities not conducted for a profit. (Treasury Regulations Section 183-1(b)(1).)
(1) Amounts deductible without regard to whether the activity was conducted for a profit are allowed in full. This category includes residential housing interest that would otherwise be deductible and property taxes.
(2) Amounts deductible that don’t adjust basis of property. These are deductions other than depreciation, amortization and bad debts. They can’t exceed the excess of gross income less the deductions in category (1).
(3) Amounts deductible that adjust the basis of property. These are deductions for depreciation, amortization and bad debts. They can’t exceed the excess of gross income less the deductions for categories (1) and (2).
Here are factors that are considered in determining whether activities are engaged in for profit. (Treasury Regulations Section 1.183-2.)
1) The taxpayer’s history of income or losses for the activity.
2) The amount of occasional profits, if any, which are earned.
3) The cause of the losses.
4) The success of the taxpayer in carrying on other similar or dissimilar activities.
5) The financial status of the taxpayer.
6) The time and effort expended by the taxpayer for the activity.
7) The expertise of the taxpayer or his advisors.
8 ) The manner in which the taxpayer carries on the activity.
9) Expectation of profit by the taxpayer.
10) Expectation that assets used in the activity may appreciated in value.
11) Elements of personal pleasure or recreation.
Having a business plan, a separate bank account for the business, and separate formal books and records for the business help establish a profit intention. Also, records of evaluation of results and plans and actions taken to improve results also are helpful for defending a profit intention.
Distributorships for multi-level marketing operations, like Amway, have been successfully attacked by the IRS as not-for-profit when they aren’t conducted in a business-like fashion and have consistent losses.
The decision to start and have a business is a serious one. Give your business serious attention so that it generates profits, and the limitation on losses for activities not conducted for profit shouldn’t be a concern for you.