A Scenario
Working as employees for over 20 years, Sam and Martha have decided to start their own business on the side. Sam has a woodworking shop and Martha has good internet skills. Looking through the local phone book they discover no one is selling hand carved and painted plaques of Holstein milk cows. So, they buy some wood supplies and paint, pay $20 for a website template, and go to work.
During the first year, they sold two plagues for a total of $100 and incurred $1500 of expenses for production supplies, auto mileage and office expenses. Their tax preparer added a business schedule with an office in home deduction ($400) to their return. Altogether, they reported a loss of $1,800 that offset some of their wages, resulting in a tax refund of $270.
The second year Sam bought woodworking tools ($500) and Martha engaged a website developer ($300). Their business loss is $2,600, and they receive a refund of $390. In the third year, they sold a few more plagues but bought a computer and incurred a loss of $2,500 producing a $375 refund.
A few months after filing their last tax return, they receive a kind and loving letter from the IRS. It stated that the cow plague activities appear to be a hobby and not a business. In fact, the IRS continued, their deductions for the three years had been disallowed and they owed $1,500 in back taxes, including compounded penalties and interest.
What are the IRS Basic Rules?
• Activities must demonstrate taxpayers are engaged in a business for profit, including good planning and management.
• If the activities are not clearly engaged in for profit, losses cannot be used to offset other income.
• The IRS presumes an activity engaged in for profit will make a profit in at least 3 out of 5 consecutive years.
• If there are losses in more than 2 consecutive years, the taxpayer is responsible for furnishing factual evidence the activity was engaged in to make a profit. When losses exceed more than two years, proving this may be difficult!
What About Sam and Martha?
There was not much business planning, and the need for some expenditures appears questionable. Engaging a website developer may be wise, but it begs the marketing question, “How will they get people to visit their website?”
They have incurred three years of consecutive losses and the IRS obviously doubts their ability to make changes to earn a profit. Providing factual evidence that they are in business to make a profit will be difficult, and the IRS will likely prevail.
This is my opinion; what’s yours? Email me your comments or questions about this scenario or other matters at larry@larryperrycpaservices.com .