Self employed tax question. Business vs. hobby...?

Question

I was talking to my mother this afternoon and she told me that her accountant said that if she doesn't show a profit this year that the government will shut her business down and not let her claim any deductions; that they will consider it a hobby rather than a business. This will be her 3rd year filing taxes for her shop. It is a metaphysical studio that has a gift shop and holds classes and groups. She and I have never heard of such a thing. I thought that most young businesses don't show profit for years! Is it possible for her shop to be shut down? If so, is there anything she can do to prevent this from happening? She is just a wreck and I told her I would see what I could find out. Thanks for your help!

Answer 1

Your mom's accountant sounds overzealous. While the IRS could determine that her business is a hobby, it is not likely this will happen unless she gets audited, and even then there are many criteria other than profit. My father operated a vending machine business for nearly 15 years, never showing a profit, audited twice, no problems.

Answer 2

First of all, no one is going to shut down the activity simply because it is unprofitable.

Whether an activity is a business or a hobby is a facts and circumstances test. Generally, if an activity makes a profit in three out of five year, the IRS presumes that the activity is a business. This is known as the safe harbor rule.

If the activity does not show a profit for three of the last five years, all is not lost. However, if the IRS claims the activity is a hobby and not a business, you must prove that the activity is a business an not a hobby. Factors that will be considered include:

The manner in which activity is conducted, maintenance of books and records, expertise in the activity, amount of time and effort devoted to the activity, whether there are employees, is there a reasonable expectation of asset appreciation, do profit motives outweigh any elements of personal pleasure or recreation associated with the activity, etc.

All these factors and others will be considered. If the activity is found to be a hobby, your mother will not be able to deduct the losses derived from the activity, and could be assessed back taxes (if she deducted losses from the activity in a prior year).

Answer 3

The IRS isn't going to shut her business down. If they look at it as a hobby, they might not allow her to deduct business losses beyond the business income for awhile until she gets profitable. There's not a specific time frame for making money, but if she hasn't made a profit any one of her first three years, they might start questioningf whether it's really a business - the rule used to be that if you didn't make a profit in 3 out of 5 years it was automatically considered a hobby. That's changed somewhat - now the criteria is proving that you're trying to make a profit, not just indulging in a hobby. See http://www.irs.gov/businesses/small/article/0,,id=99239,00.html - print it off and give your mom a copy.

Anyway, if her worry is over being shut down, that's not going to happen so she should quit worrying - I don't know why an accountant would have said that! It's not true. But she might not get to deduct business losses from other non-business income she might have.

Good luck, to you and to her.

Answer 4

Your acquaintance is wrong on a couple of points. First, if a person has a hobby, all revenue that he takes in is gross income and reported on Line 21 of Form 1040 as "other income." Second, there is no cutoff below which an activity ceases to be a business and becomes a hobby. Expenses of the hobby may be deducted as miscellaneous deductions on Schedule A subject to a 2% of AGI floor. A hobby may not deduct a loss. A business is done primarily for a profit motive. A business may deduct a loss, but if the taxpayer continues to deduct losses for more than a few years, his profit motive is usually challenged. The IRS will assert that a business is actually a hobby, and force amendments changing the activity to a hobby.

Answer 5

I think your mother needs to find another accountant. The government would not shut her business down if they ruled it a hobby rather than a business. While the IRS does have a rule called 3 out of 5 for a business (you would need to show a profit for 3 out of 5 years for it to be a business rather than a hobby), that is not the only criteria for deciding whether something is a hobby or a business. If your mother has kept separate books for her business, tried to do different things to make the business profitable, how much time she devotes to the business, how knowledgeable she is about her business, etc. She can still claim losses on her business, it's only if the IRS tells her that they think it's a hobby rather than a business is when she might have a problem. If this is something that she is devoting 100% of her time to, or devoting more of her time each year to the business than it's likely that the IRS will recognize that she is trying to make a profit of it, and not declare it a hobby. If her business is ever declared a hobby, the government would not shut down her business, but she would not be allowed to deduct losses for her business.

Answer 6

Assuming you have all of your business licensing, that is not true. They cant force you to shut down because you aren't making money. Assuming you can prove all of your losses and that they are legitamate, you can continue to take a loss annually. There are some stipulations though:

You must be actively involved in the business. If you are not at risk of losing everything and you are not spending a significant amount of time in the business, then it can be classified as a passive business activity, in which case you can only write off a few thousand a year in losses.

All of your expenses must be ordinary and necessary in your field of work. Keep an eye on your writeoffs. A business facing continual losses will be a big flag for an audit, especially if you are a sole proprietorship.

Hobby income versus loss works like this: Say I build model airplanes and buy and sell some here and there on the side when I have extras I don't want. Lets say I dont have a business license and just do this for fun. I need to claim the money I make as income. I cant claim losses on sales I lose money on or write off the glue I used to put them together, but I can use the losses to offset profit I made on other plane sales.

Answer 7

I read about this in the Wall Street Journal this week. The article says, "You need to demonstrate that you are continuously and regularly in business for the primary purpose of making a profit." Regardless of whether or not she made a profit, I'm assuming.