If you’ve ever dreamed of turning a hobby or vocation into a regular business, there are seven steps Isler CPA encourages entrepreneurs to take to avoid running afoul of the IRS and the Oregon Department of Revenue. Under the so-called hobby loss rules, your deductions for business-type expenses (such as rent, travel, meals or advertising) may be limited to your gross income from the hobby. Expenses over the income amount would not be allowed. Also, allowed hobby expenses are claimed on Schedule A of Form 1040 as miscellaneous itemized deductions subject to a 2%-of-AGI “floor” and not as a direct offset against the income. By contrast, if the new enterprise isn’t affected by the hobby loss rules, all otherwise allowable expenses would be deductible on Schedule C, even if they exceeded income from the enterprise. To avoid the Hobby Loss treatment, you need to be able to show that the business was entered into with the primary purpose of making a profit, not primarily to provide you with other satisfaction. Factors that the IRS and courts look to when determining whether you have met the “for profit” purpose include the following:
- Document: If the maxim of real estate investing is location, location, location, the maxim of audit-free or pain-free audit business management is document, document, and document. Every transaction should be documented by vendor, date, amount and purpose and receipts should be retained for at least three years, or seven years for larger transactions.
- Business plan: Documenting how income will be earned, who are the target clients, and which services are offered, is helpful in guiding a new business owner, and also supports the assertion that the business owner is “in it to win it!” and not a sham to create tax advantageous deductions. You need to follow your plan, and update it, when needed.
- Accounting system: Among the first steps an entrepreneur should consider is which type of accounting system to use. At first, this may be as rudimentary as a ledger sheet, or an excel document, but most businesses in Oregon use QuickBooks. An important piece of the accounting system should document the funds distributed to the owners, not just income and expenses.
- Separate bank accounts: The IRS is suspicious of businesses where the owner is commingling funds with their personal account. This also helps keep your books clean, and provides some loose liability protection from a lawsuit where the entity is structured right. #talktoalawyer
- Choice of Entity: By establishing the appropriate entity, taxpayers show they are serious business people. Where a proprietor is operating alone with no entity, the income is simply reported on the schedule C attached to the 1040. To increase the sophistication of a business, taxpayers should register with the Oregon Secretary of State (sos.oregon.gov/Pages/index.aspx), especially where there are employees or licensing requirements. Taxpayer must take into consideration ownership arrangements, personal liability protections, and tax consequences as to whether a partnership, S-Corp, LLC, or C-Corp will best meet your needs. We will work with your attorney to help with your decision.
- Advertising: Taxpayers will show they are working to make money by advertising to the public. This can proven by using business cards, a website, yellow pages, or other publications aimed towards the target audience.
- Time: A business owner should be able to show material participation, which has been defined in various ways, including regular, continuous and substantial participation for more than 100 hours during the tax year.
If your new business is profitable three out of five consecutive years (two out of seven years for breeding, training, showing, or racing horses), and you follow the steps outlined above, Oregon and the IRS will have the burden of proving you are not involved to make a profit. The laws assume in these situations that you meet the standards, and the IRS has the burden to prove otherwise. However, if the enterprise consistently generates losses (deductions exceed income), you will have the burden of proving you are not involved in a hobby.
Isler CPA guides our business owners to step up their seriousness, using these seven steps above, before the IRS steps in years to come!