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The IRS Wants to Know, Are You Running a Business or a Hobby?
Being a small business owner comes with many challenges. It’s not just about meeting the needs of your customers, getting paid, and paying your vendors. You must also ensure that you comply with federal and state laws and local guidelines. Small business owners, especially sole proprietors, are at increased risk of inspection. The federal government believes that self-employed people grossly underreport their income and overstate their expenses. According to Tax Help Online, “You may be shocked to learn that 20% of all small business audits involve denials of deductions because the IRS classifies a small business as a hobby under the so-called “hobby loss” rule.” Section 183 of the Internal Revenue Code (Nonprofit Activities) limits the deductions that can be claimed when an activity is conducted not for profit. IRC 183 is sometimes referred to as the “hobby loss rule.” As a small business owner, it’s your responsibility to make sure your business is considered a legitimate business in the eyes of the IRS, not a hobby.
Below are some smart business practices that will not only help you define and develop your business, but also document that you are running a real business, not just a hobby.
1) Write a business plan. There are many local small business support centers that can help you put your plan in writing. For example, the Small Business Administration can help you with local and online resources.
2) Determine your legal structure (LLC, Partnership, C-Corporation, S-Corporation, Sole Proprietorship).
3) Get an Employee Identification Number (EIN) from the IRS.
4) Open a separate bank account for all your business transactions (deposits and expenses). You must keep your personal and business transactions separate.
5) Create a separate line of credit or credit card for your business. Put personal expenses on a personal card and business expenses on a business card.
6) Keep your business documents organized. The National Association of Independent Business recommends keeping business records and receipts for at least seven years.
7) Submit the completed tax returns on time. This includes all necessary schedules and signatures. Depending on the type of organization, you or your CPA will fill out forms such as 1020, 1065, 1040 Schedule C, 1096, 1099, 940, along with self-employment tax calculations. I strongly recommend that you find a local Certified Public Accountant (CPA) who knows your industry to help you determine which forms you need to file and make sure they are submitted on time and to the appropriate government agency.
8) Hire a support team: An attorney can help you with your legal structure, and a CPA can help you keep your finances in order and comply with local, state, and federal government regulations.
9) Create industry standard business documents and forms including: logo, letterhead, business cards and website.
10) Advertise in local media along with appropriate trade magazines.
According to IRS document FS-2008-23, below are some of the questions the IRS may ask when determining whether your business is engaged in a for-profit business. You should be prepared to answer these questions and submit the documents.
1) How many hours a week do you work in the business?
2) Do you depend on the income from this activity to pay your bills?
3) Do you have the necessary knowledge to successfully continue the activity?
4) Have you made a profit in a similar activity before?
5) Will the activity bring profit in a few years?
6) Do you expect the activity to be profitable in the future?
7) Are there elements of personal pleasure or recreation?
8) Has your business been profitable in 3 of the last 5 years?
According to IRC 183, “If your business is not carried on for profit, the deductions allowed shall not exceed the gross income from the business.” The result is that business deductions now become itemized deductions and are limited to hobby income.
For more information and assistance in keeping your company a legitimate business, contact your local CPA. Each state has its own independent licensing board. If you are in North Carolina, contact the NC CPA Board website and click on the “Find a Licensee” button to find a CPA near you. This website lists all licensed and active CPAs in North Carolina.
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