Keep Your Home Business a Tax Chomping Machine

 

              By Sandy Botkin, C.P.A.

 

              CRITICAL STEPS TO MAINTAINING BUSINESS STATUS WITH THE

              IRS

 

              So, you finally decided to start your own part-time home business. You have

              gathered sufficient inventory and equipment to run it. You have a marketing plan

              of attack to make lots of money, and all you need to do to keep the IRS off your

              back is save all receipts, right? WRONG!!

 

              One of the IRS's favorite weapons is to treat a home business as a hobby, not as

              a legitimate business. Even if you have all the receipts in the world, classification

              of your endeavor as a hobby will limit your "business" deductions to the income

              from the activity. If the deductions exceed your activity's income, the excess is

              completely eliminated!

 

              If, however, your endeavor is classified as a business and generates a loss in the

              first couple of years, you can subsidize your business by reducing the taxes you

              pay on any other source of income such as your wages, rents, dividends and

              pensions. You can even even reduce the tax that your spouse would pay on his or

              her salary. In addition, if your losses exceed your family's income, you can either

              carryback the loss three years and get a refund from the IRS, or carry it forward

              15 years and offset up to the next 15 years of income. Thus, knowing how to

              maximize the chances your endeavor will be treated as a business makes a

              difference as to whether your activity survives.

 

              The following example will explain this:

              Example: Wayne incurred a $10,000 loss from his part-time business. If he

              earns $40,000 as an employee, his taxable income for the year will be only

              $30,000. If, however, the IRS classifies his ''business" as a hobby, he will not be

              able to use the $10,000 loss and will have to pay tax on the full $40,000.

 

              Thus, the real question is when are you conducting a business vs. a hobby?

 

              The good news is that there is a safe harbor area which, if met, puts the burden of

              proving your activity is not a business on the IRS. Generally, if you have a profit

              in three out of five consecutive years, the IRS has the burden of proving your

              activity constitutes a hobby.

 

              TIP: Once a profit is shown to occur in three out of five consecutive years, the

              IRS rarely, if ever, challenges the endeavor as a hobby.

 

              The problem is that in these cases, the IRS rarely waits the full five years to see if

              you have a profit. Congress, therefore, provides an election to file with your tax

              return to force the IRS to wait the requisite time period.

 

              TIP: Although this election sounds good on paper, don't bank on it. It calls

              attention to your return and extends the statute of limitations for the IRS to catch

              you.

 

              Thus, if you don't have a profit in the requisite time period, what happens? This is

              purely a myth. The IRS states in its regulations that as long as you operate your

              endeavor as a business in the pursuit of profit, you can still claim all business

              losses generated, without limit.

 

              Unfortunately, there is no safe harbor here, just some guidelines. However, if you

              review the following criteria carefully, you should be able to overcome almost any

              challenge.

 

              Criterion One: What were your motives at the time you entered into the

              activity?

 

              You need to document your intent to investigate this activity as to its profitability.

              Feasibility studies, consultations with experts, and documented financial

              statements of similar activities help establish that you entered your activity to

              pursue a profit.

 

              It is also vitally important to prepare a business plan for at least five to ten years.

              This plan shows the estimated income and expenses over the foreseeable ten

              years.

 

              Criterion Two: Did you make any statements or did any statements in the

              marketing materials indicate a not-for-profit motive?

 

              The IRS will generally not believe your own self-serving statements that you

              entered your activity to make money. However, any statements made to the

              contrary, will be held against you. Don't ever tell anyone you entered the activity

              simply to save taxes or get some discounts. The IRS will use your own statements

              against you.

 

              Criterion Three: Do you conduct your activity in a business-like manner?

 

              Businesses generally keep good accurate records, hobbies don't. You should

              have a separate bank account (with no co-mingling of personal funds) for your

              business. You should use the financial statements generated each year to prepare

              a budget so you can try to reduce expenses, and most importantly, you need to

              keep a good tax diary of your mileage, appointments, entertainment and travel

              expenses.

 

              Tip: A good tax diary is one of the most important audit-proof documents you

              can have. It documents appointments, mileage, entertainment and travel reasons

              and expenses. This is one item all business people cannot do without.

 

              Criterion Four: Do you run your endeavor like a similarly profitable business?

 

              You should try to show that your activity is carried on in a similar manner to other

              profitable ventures.

 

              Thus, you would want to show you advertise your business, print up business

              cards and stationery with your address and phone number, develop promotional

              literature, maintain a business telephone listing, and use a variety of marketing

              strategies.

 

              Criterion Five: What was your prior business experience?

 

              If you have no prior experience doing this activity, it becomes more questionable

              as to whether you ever had a profit motive. This can be overcome, however, with

              proper documentation showing you did extensive investigation of the activity

              before starting it, you participated in extensive training and study to make the

              activity a success, and attended a number of seminars in your field of endeavor.

 

              TIP: You can never get enough training, especially if you have no prior

              experience in this field.

 

              Criterion Six: What is your history of losses and income and what steps did you

              take to improve your profitability?

 

              This is a major factor with the IRS. You should do almost anything legally and

              morally necessary to turn any business losses into profits. Again, it is essential to

              document all training taken, consultations with experts, marketing activities,

              reasons for business trips, noting the intent and necessity for making the trip.

 

              Criterion Seven: Do you devote some time in a regular manner to your activity?

 

              Although you certainly do not need to devote full-time to your business, the more

              time and effort, the better. Cases have shown that as little as one hour per day (or

              more) on the average can be sufficient to support a profit motive.

 

              Observation: Businesses are conducted regularly, hobbies are not. One hour a

              day for four days a week is better than eight hours every two weeks.

 

              Criterion Eight: What is the amount of income from other sources?

 

              The greater your income from other outside sources such as wages, pensions,

              etc., the less likely your loss from your activity will be deemed a business loss.

 

              Criterion Nine: Are you in an inherently suspicious activity?

 

              The purpose of the hobby loss provisions is not to eliminate losses from

              businesses no matter how poorly run. It is designed to attack people who are

              starting a business as a sort of "tax shelter." There are some activities that get

              closer scrutiny than others such as: antique collecting, stamp collecting, traveling,

              ministerial duties, writing, racing, training, record recording and other similar

              ventures. If you are attempting any of these, you must dot your i's and cross your

              t's. HBM

 

              Sandy Botkin CPA, Esq., is the president of the Tax Reduction Institute (TRI Seminars) of

              Germantown, Maryland. He provides continuing education seminars for real estate

              professionals nationwide and is the author of the acclaimed series, ''Tax Advantages for

              Home Based Business" and "How To Sell More Real Estate Using Tax Knowledge" He is

              also the author of the article, "How to Analyze a Good Network Marketing Opportunity".

              You can order either of his nationally acclaimed tax systems by calling 602-874-1719.

              For questions on his seminars, booking a seminar or getting a copy of his article on

              home-based business, call 301-972-3600.