Forums: Discussions for entrepreneurs and small business.

Greetings everyone.  I`m hoping someone can confirm or debunk what my tax guy is telling me.  My wife has a home based embroidery business and we have been claiming it on our personal income taxes for the past four years.  My tax guy informed me that the IRS requires that a home based business MUST show a profit two out of every five years, or it`s considered a hobby and therefore cannot be used as a deduction.  My question:  Is this true or not?  I ask this primarily because a friend of mine also has a home based business which he says he has been claiming losses just about every year since he began it seven years ago.  The business is his primary source of income, while my wife`s is more like a second job at this point. Also, I don`t know his corporate status, whether he`s an LLC or what.  We are strictly a mom and pop type operation right now.  If you know of a particular IRS reg, that would help me immensely.

 

Thanks for the help on this.

Mark

Actually, this guy is taking a conservative approach

 

An activity is presumed for profit if it makes a profit in at least three of the last five tax years.  The IRS guidelines do not state that NOT making a profit in three of the last five years makes the business a hobby and instead offers the following advice.

 

The following factors, although not all inclusive, may help you to determine whether your activity is an activity engaged in for profit or a hobby:

In any case, IF your activity is not carried on for profit, allowable deductions cannot exceed the gross receipts for the activity.  So you will not have a tax loss, but you will not owe income tax on any income.

To be fair, the IRS now fines paid preparers who take positions that do not have a reasonable change of being upheld.

Thanks, Ken

 

Do you by chance know of an IRS reg that cites this.  I`d like to be able to use this to make my accountant feel more at ease.

 

Mark

 

 

The rules are in several publications and what the IRS calls `articles` on their website.

 

There is reg 183.1 through 183.4 if you need to get techincal.

I`ll bite on the vague comment.  Please elaborate.

 

Mark

 

 

Actually, there is a 3 of 5 rule, if the business makes a profit in 3 of the last 5 years, it IS a for-profit business, end of story.  If a business does NOT make a profit in 3 of the last 5 years, then there is a list of items that could point to the venture being a for-profit business vs. a hobby.

 

That is one reason to ALWAYS have separate business accounts (bank and credit) from personal.  If you need money from your business, write a check to yourself.  If you pay for something via your personal credit card or the cash from your pocket, send your business an expense report.  This will not prove for-profit intent, failing the 3 of 5 rule, but not doing so does point to the venture being a hobby.

 

I could see someone missing this nuance, but since the IRS rules are really one nuance after another and this is not a very obscure rule, I agree with Mr. Mann.