Business Profits and Losses and Taxes
Making a profit should be a basic fact of business. But what if you aren't making a profit? How does that affect your business taxes?
Many new business owners don't make a profit in the beginning. In fact, for some, it takes many years to make a profit. If your new business is not making a profit, you may be concerned that the IRS will deny your business expenses as deductions. The rumor is that you have to be profitable within the first five years. The IRS "presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years." The IRS determines that, in absence of other evidence, a business which doesn't make a profit is a "hobby loss business," in other words, just for fun and not a legitimate profit-making business. But other factors come into play in the determination of whether a business is a profit-making entity and can deduct business expenses.
Read more about what the IRS says about "Business or Hobby?"
Engaging in a Business for Profit
What does it mean to engage in a business for profit? There are several factors involved, as described in a recent Tax Court case. In this case, the taxpayer was running an athletic coaching business. In the first 8 years, he did not make a profit, because of many expenses traveling around with elite athletes. Then he finally began making a very small profit.
The IRS said this business, a private coaching activity for runners, was "not engaged in for profit." In order to have expenses allowed as a business deduction, the business must have a "predominant, primary or principal objective of realizing an economic profit independent of tax savings." That is, the purpose of the business should be to make a profit, not just to reduce personal taxes. The IRS says that a business that doesn't make a profit three out of five years may be at risk of not having expenses allowed as deductions.
Factors reviewed by the Tax Court
In this case, the Tax Court looked at several factors, including profitability, to make its determination.
- Is the business carried on in a business-like manner? Are good business records kept? Are business and personal expenses kept separate?
- Does the business owner have expertise or expert advisors? In this case, the owner had expertise in running, but got paid expertise from others who had been successful coaches.
- How much time is spent in this activity? This doesn't mean the business must be full-time, but it must be engaged in a reasonable amount of time in order to make a profit. A business that you work on only a few days a month probably isn't going to be profitable and it looks more like a hobby than a business.
- Have you been successful in similar or other activities? If you have successfully sold craft products or you have been successful at another business, even if it is not similar to the current business, it shows you have expertise at running a business and you are likely to be profitable.
- What the history of income and loss for the business? As noted above, a continuous string of business losses with no years of profit is a negative factor in the determination.
- Have you ever had a profitable year? Even one profitable year shows an intent to make a profit.
- What is your financial status? Can you show that expenses were used to further the business profit and not just for your own enjoyment? Many travel expenses might be necessary but you may have to prove that. Expenses for materials for products you sold are a better indicator of your intent to make a profit.
- Is this activity for personal pleasure or recreation? A business coaching young athletes might be for pleasure, but given the amount of time and high expenses, it's probably not. A business making quilts that don't get sold is more likely to be looked on as a hobby.
The Tax Court in its conclusion stated that even with the negative factor of no profits for 8 years, the Court noted that the losses were decreasing and the potential for success was improving and they determined that the business was formed with the intent to make a profit.
Note This case should not be taken as a precedent. Every case is different and a similar case might have enough differences to cause a different Tax Court to rule differently. The intent of this article is to show the factors reviewed by the Tax Court in these kinds of cases. If you are have questions about your business profits or a specific IRS or Tax Court case, consult your tax advisor.
Source: T.C. Summ.Op. 2012-105(PDF)