Large losses on a taxpayer’s Schedule C, Profit or Loss from Business (Sole Proprietorship) tend be a red flag waving in the face of the IRS. And when this happens for too many years, those tax returns can be especially inviting to closer examination.
Consider the following cases:
- An artist operates for many years, reporting losses in all but two years of the last few decades.
- A sports memorabilia agent operates for many years, with relatively small profit on a few years and significant loss in the three years under review.
On the face they appear to be considering the same issue and, you would think, reach the same conclusion – each one is a sole proprietor who completed a Schedule C on their individual returns and reported big losses, some that carried forward for years — looks like these are probably expensive hobbies.
The list below is of factors that are under consideration when determining whether a taxpayer has a profit motive – and that’s where things between these two cases are vastly different.
The list, not exclusively, is the following:
- The manner in which the taxpayer carries on the activity
- The expertise of the taxpayer or his advisors
- The time and effort expended by the taxpayer in carrying on the activity
- The expectation that assets used in the activity may appreciate in value
- The success of the taxpayer in carrying on other similar or dissimilar activities
- The taxpayers history of income or losses with the respect to the activity
- The amount of occasional profits, if any, which are earned by the taxpayer
- The financial status of the taxpayer
- Elements of personal pleasure or recreation
No single factor is conclusive, and the court can afford greater weight to one over another given the facts and circumstances of each case. These two Tax Court decisions regarding sole proprietorships have given insight into what the court looks at, and how carefully they consider, all information and circumstances when profit motive of a sole proprietor is in question.
So, carefully consider now – is your side hustle for love or money? How will you prove it if the need arises?
Here are a few suggestions:
- Keep accurate and timely records
- Devote time to the business side of your activity – inventory, recordkeeping, networking, and follow-up
- Develop your experience and consult with experts in the field
- Determine if your business is, or reasonably may be in the future, a means of support for yourself or family
- Dedicate significant portions of your personal time to the pursuit of creating a profit in your business
- Cultivate new skills and periodically evaluate and change, as necessary, your business practices to be more profitable
- Enjoying your business is acceptable, but there should be definite elements of demand and market for the goods, products, or services
This article was first published on LinkedIn via LinkedIn Pulse on October 22, 2015.