If you run a small business and report income and expenses on a Schedule C, the last thing you want is for the IRS to categorize your endeavor as a hobby. Why? Because hobby losses aren’t deductible, while business expenses are. The IRS scrutinizes businesses that consistently report losses, and if they suspect your business is more of a “hobby,” you could find yourself facing a Schedule C “Hobby Loss” examination. Here’s what to expect and how to defend your business if you’re audited.
What is a Hobby Loss Exam?
The IRS uses the “hobby loss” rule under IRC Section 183 to prevent taxpayers from deducting losses from activities that aren’t conducted to make a profit. If your business hasn’t generated a profit in three of the last five years (two out of seven for horse-related activities), the burden of proof to show your profit intent moves from the IRS to you. In that case, the IRS may challenge the legitimacy of your deductions. This triggers a “hobby loss” examination, where they’ll determine if your business is a legitimate for-profit activity.
Proving Your Business is Not a Hobby
If you’re facing a Schedule C audit, the burden of proof is on you to show that your activity is a business with a profit motive. The IRS looks at several factors, including:
- Business-like Manner: Do you keep accurate books, maintain separate bank accounts, and professionally conduct your activity? The more you treat your business like a serious venture, the better your chances.
- Time and Effort: Do you spend significant time and effort in the business, or is it more of a casual pastime? Documenting your working hours and your attempts to grow and improve the company will help bolster your case.
- Expertise: Do you have knowledge or expertise in the industry? Showing that you’ve sought advice, attended relevant training, or engaged with professionals in your field strengthens your claim.
- History of Income and Losses: While reporting losses is not unusual for new businesses, a pattern of profitability, even if sporadic, helps demonstrate intent. You don’t have to show profits every year, but consistent and serious efforts to make the business profitable are crucial.
- Appreciation of Assets: If your activity involves assets that appreciate over time (like real estate or collectibles), it suggests a potential for profit, even if income isn’t immediately apparent.
Preparing for the Exam
Gather and organize your financial records if you receive notice of a Schedule C exam. Documentation like receipts, invoices, contracts, and tax returns are essential. In addition, prepare a narrative that explains your efforts to make a profit, any challenges faced, and your future business plans. It’s also helpful to work with a tax professional experienced in defending hobby loss exams, as they can provide guidance on specific documentation the IRS may request.
Conclusion
While facing a Schedule C “Hobby Loss” exam can be stressful, being proactive and organized in demonstrating your profit motive can turn things in your favor. By treating your business seriously and documenting your efforts, you can defend your deductions and keep your tax bill in check.
