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Avoid Being an IRS Target When Your Business Loses Money

4/19/2018

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If you operate what you think is a business, but that business loses money, it may not be a business at all under the tax code. Such a money-losing activity can look like a tax shelter to the IRS, and that substantially increases your chances of an IRS audit.
 
The tax code contains a business loss safe harbor that’s known as a presumption of profit. You meet this safe harbor when your activity produces a profit in three of five years (two of seven for breeding, training, showing, or racing horses). When you meet the safe harbor, you are presumed a business unless the IRS establishes to the contrary.
 
We know this for-profit tax code section as the hobby loss section. But you can see that this tax code section creates trouble for much more than what you would consider a simple hobby. Here’s an example of how badly the recent tax reform under the Tax Cuts and Jobs Act can treat a business that loses money.
 
Example. Billy has an activity that fails the business test and loses money. Last year, he had $70,000 of income and $100,000 of expenses. Under pre-tax-reform law, Billy could claim the hobby-related business deductions up to the amount of his income. So Billy deducted $70,000 (subject to some minor adjustments) and reported close to zero taxable income.
 
Not this year. Tax reform is going to make Henry suffer. With the same facts, Henry’s business deductions are zero. His taxable income is $70,000. Think about that. Billy lost $30,000 ($70,000 - $100,000) in real money. He now pays taxes on $70,000 of phantom income.
 
What can Billy do to make this problem go away? He has two choices.
 
  • First, he could create a “for profit” business defense in the hope that he would defeat the IRS in an audit.
 
  • Alternatively, he could stop the taxation on his phantom income by operating his activity as a C corporation.
 

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    Spencer Accounting Group, LLC does not provide investment, tax, legal, or retirement advice or recommendations in these blogs. The information presented here is not specific to any individual's personal circumstances.

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    To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
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    Author

    Keana Spencer is an Accountant, Entrepreneur, and Educator to her clients, with a strong passion.  Keana has over 10 years of experience and through her practice, she is a source of knowledge and strategies to her clients.

    Keana founded this website and decided and created this blog page to offer a space for those seeking knowledge to understand, however not to be confused with advice or planning strategies.

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