February, 2004 Tax Newsletter

Is Your Business Really Monkey Business
 

In order for expenses relating to an activity to be deductible, the activity must be entered into for profit.  It may be argued that most people who journey into an endeavor do so with the intention of making money.   The IRS and the courts, however, will look to several factors surrounding the activity, including the manner in which it is operated, in determining whether the business is a bona fide business for tax purposes or whether, in reality, it is an activity engaged in for pleasure or hobby. If the activity is regarded as a business, rather than a hobby, you're entitled to deduct legitimate business expenses which, of course, reduces your tax bill at the end of the year.  This is without regard to whether the activity shows a loss.

Many, if not most businesses do not operate profitably right off the bat.  It may require one or more years of effort to get the operation turned around.  However, if you go in with the realistic intention of ultimately getting paid for your goods or services you very likely have a profit motive in mind.  You don’t have to be working full time or intending to make the activity your principal source of income to have a profit motive.  Also, there is nothing inherently wrong in enjoying what you do.

It is very important to keep in mind that profit motive is more important than actually making a profit.   Ending up with a loss doesn't mean your deductions will be disallowed.  You may have heard of the "3 out of 5 year rule".  Many misinterpret this rule to mean that an activity must make a profit in 3 or more out of  5 consecutive years to be considered a business.  What the rule is really all about is presumptions.  The rule says that if you make a profit in at least 3 out of 5 consecutive years, the presumption is that you are conducting a business.  This is an extremely important concept.  It means that, in an audit, the burden of proof is on the IRS to show that you did not have a profit motive.  It is not a burden the IRS cherishes taking on.  However, if you do not make a profit in at least 3 out of 5 consecutive years, the burden of proof that you are in a business and conducting yourself as a business shifts to you.  All the IRS has to do is challenge the activity as a business and it will be up to you prove that it is.

So what does this mean?  If you are in your third year of your operation and you showed losses in the first two years and are facing a loss in the current year, don’t be reluctant to report the loss on your return if you truly believe that you have the requisite profit motive.  Just know that you may be called upon to prove your position.  By the time that happens, the business may have already turned around and be operating profitably.  This would certainly lend strong support to your case.