The IRS wants to know if you have a business or a hobby.
Being a small business owner comes with a host of challenges. It is not only concerned with taking care of the needs of its customers, collecting and paying its suppliers. You also need to be concerned about complying with federal and state laws, as well as local guidelines. Small business owners, especially sole proprietors, are at a higher audit risk. The federal government believes that the self-employed are underreporting their income and overreporting their expenses. According to the Tax Help Online website, “You might be surprised to learn that 20% of all small business audits involve not allowing deductions because the IRS reclassifies small business as a hobby under the so-called ‘loss of hobbies rule. ‘”. Section 183 of the Internal Revenue Code (Nonprofit Activities) limits the deductions that can be claimed when an activity is not for profit. IRC 183 is sometimes called the “hobby loss rule.” As a small business owner, it is your responsibility to ensure that your business is viewed as a legitimate business in the eyes of the IRS and not as a hobby.
Below I’ve listed some smart business practices that will not only help you define and grow your business, but will also help you document that you are running a real business and not just doing a hobby.
1) Write a business plan. There are many local small business support centers that can help you put your plan in writing. For example, the Small Business Administration has local and online resources to help you.
2) Determine your legal structure (LLC, Partnership, C Corporation, S Corporation, Sole Proprietor).
3) Obtain an Employee Identification Number (EIN) from the IRS.
4) Open a separate bank account for all your business transactions (deposits and expenses). You must keep your personal and business transactions separate.
5) Establish a separate line of credit or credit card to use with your business. Put personal expenses on a business card and put business expenses on a business card.
6) Keep your business documents organized. The National Federation of Independent Business recommends keeping business records and receipts for at least seven years.
7) Submit completed tax returns on time. This would include all required timetables and signatures. Depending on the type of organization you have, you or your CPA will fill out forms like 1020, 1065, 1040 Schedule C, 1096, 1099, 940 along with your self-employment tax calculation. I highly recommend finding a local Certified Public Accountant (CPA) who is familiar with your industry to help you determine which forms you will need to file and ensure they are sent on time and to the appropriate government office.
8) Hire a support team – An attorney can help you with your legal structure and a certified public accountant can help you keep your finances in order, as well as comply with local, state and federal government regulations.
9) Create industry standard business documents and forms to include: logo, letterhead, business cards, and website.
10) Advertise in local media along with appropriate trade periodicals.
According to IRS document FS-2008-23, below are some of the questions the IRS can ask when determining whether your business is engaged in a for-profit activity. You will need to be prepared to answer these questions and provide documentation.
1) How many hours a week do you work in the business?
2) Do you depend on the income from this activity to pay your bills?
3) Do you have the necessary knowledge to develop the activity as a successful business?
4) Have you made a profit from similar activities in the past?
5) Does the activity make a profit in some years?
6) Do you expect the activity to generate benefits in the future?
7) Are there elements of personal pleasure or recreation?
8) Has your company made a profit in 3 of the last 5 years?
According to IRC 183, “If your business is not for profit, the allowable deductions cannot exceed the gross income from the business.” The result is that your business deductions will now become itemized deductions and will be limited to your hobby income.
For more information and assistance to help your business maintain its position as a legitimate business, contact a local CPA. Each state has its own independent licensing board. If you are in North Carolina, you can contact the NC CPA Board website and click the “Find Licensee” button to locate a CPA near you. All active and licensed public accountants in North Carolina are located on this website.