Welcome to TaxView with Chris Moss CPA
Millions of Americans start new business each year and become Sch C sole proprietors, small partnerships and single member LLCs. Some of these businesses almost immediately make large profits. But an even larger number of businesses struggle for the first few years to develop market share and incur large losses. Lurking in the path to success for many of these new business owners is an overlooked IRS trap found in Section 183 of the the IRS Code called the “hobby loss rule”, If you should unfortunately fall into the hobby loss trap, the IRS will immediately and painfully disallow your start up losses as well as attempt to clean out your wallet. So if you are thinking of starting a new business stay with us here on TaxView with Chris Moss CPA to find out how to keep your family protected from IRS attack and stay clear of the Hobby Loss trap.
So when is your business in danger of getting snared by the IRS hobby loss trap? Let me introduce you to Bill, who has been reading a lot about how home security is a profitable business. Bill told me he decided to take an early retirement as a government auditor. He realized he would be taxed heavily if he cashed in his 401K to start the business, but his wife's sister Jane who is a part-time bookkeeper said not to worry because he could offset losses against income,. In fact Bill said to Jane she can come work for him to do the books as soon as he can afford to hire her,.
Fast forward a few years, Bill works 40 per week trying to market and develop the Security for Life brand and to service his growing customer bases. But he also has to keep his prices competitive to maintain market share and to develop his brand and good will in the community. As a result, his profit margins have been slim and has incurred substantial losses.
After a few years of losses, Bill gets his first break, a new contract providing security for new home construction with a large local builder. He rushes home to tell his wife, but before he can say a word his wife hands Bill a notice from the IRS, an IRS field audit notice. He panics and calls his sister in law Jane. who immediately refers Bill to her friend Susan a tax attorney.
Susan tells Bill the IRS audit most likely is going to focus on whether or not there is sufficient profit motive to deduct the losses each year and avoid the Hobby Loss trap.. Bill is further told about Regulation 1.183-2(b) which lists 9 factors to be considered in determining whether an activity is engaged in for profit. Jane says there are three key factors which will apply in this case:
(1) manner in which Bill carries on the business;
(2) Bill's expertise in his industry.
(3) Bill's time and effort in the business.
Bill at first feels great. He clearly works a lot of hours.. But Susan is not feeling so well.
As a tax attorney she believes Bill loses on (1) and (2) based on various US Tax Court cases she is aware of.. She sits Bill down and goes over with him Giles v IRS decided in 2006. In this case Giles had a horse breeding business which did not have proper books and records sufficient to impress the Court that Giles was anything but a hobby. Judge Gustafson notes that while Giles kept basic expense categories "her records did not break down the expenses by horse, by month, or by any other means.. In the words IRS wins Giles loses,.
Susan points out to Bill that he hast no separate office out of the home and uses a personal phone number for his business phone. Bill did not obtain a county business license because it would have been too much trouble for him to get a home use occupation zoning exception. His checking account was not separate and distinct from his personal accounts. Even Bill’s internet service was a “personal” rather than a business account. Furthermore, Bill had no formal training in home security. Bill read lots of books and registered for many internet training sessions, but he never worked for a home security company. He refused to joint venture with a competitor, and refused to trademark his brand “Security for Life”. Bill told Susan he was just trying to save money.
In spite of all the mistakes Bill made, he still felt there was hope. He says to his tax attorney, "Let's get real, a horse business for those wealthy folks never wins in Court. On the other hand, a home security business is a down to earth real business, for real working people. But Susan politely disagrees, So she finds another horse case, the case of Helmick v IRS decided in 2009, In that case Hilmick ran a horse breeding and boarding operation, The Court in that case held that the business did not fall under the hobby loss rule in part because "the Helmicks had invested so much time and effort in this failing activity that they could see no way out except to somehow make the thing work.." Helmick wins IRS loses.
Fast forward a few more months. In fact the IRS audit did not go well for Bill. The Service claimed that Bill used the business as a “ tax shelter” for his wife’s income and his cashed in 401K. The IRS disallowed all the losses for 3 years in accordance with the hobby loss rule and assessed back taxes, interest and penalties of over $70,000.
In conclusion, the IRS is lurking out there to close the hobby loss trap on your new business start up. Hire the tax professionals who could help you make your business bulletproof from IRS audit rulings that disallow your losses. Make sure your tax attorney keeps you far away from "hobby loss" territory by creating the facts necessary to insulate you from harm in the event of an IRS hobby loss audit. Have your tax preparer fully explain in your tax return those facts before you file. Finally, work hard, grow your small business and prosper, and by all means, may your profits come sooner than later.
Thank you for joining us on TaxView with Chris Moss CPA.
Submitted by Chris Moss CPA