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Home business losses and the IRS.

In the November/December 1992 issue, Vicki Parrish offered some business advice. Her initial paragraph regarding the deductibility of losses needs clarification. There is no "magic" number of years in which one must show a profit or else face automatic classification as a "hobby" and disallowance of losses previously deducted.

The law which Ms. Parrish refers to is section 183 of the Internal Revenue Code. What this law says is that (1) deductions incurred in an activity not engaged in for profit are not deductible, except as provided by section 183, (2) it states what is deductible even when an activity isn't engaged in for profit, and (3) it raises a presumption that an activity is engaged in for profit if certain requirements are met. In the terminology of section 183, your business is an "activity."

If you show a profit in three out of five consecutive years a presumption is automatically raised that the activity is engaged in for profit. (For activities involving horses the rule is two out of seven years). This is the general presumption. Once you have shown three years of profit within five consecutive years, the presumption applies to the third year of profit and any remaining years in the five year period. For horse related activities the presumption applies to the second year of profit and any remaining years in the seven year period.

There is also a special presumption for new activities. You can make an election to delay the determination of whether you have met the requirements of section 183 until the end of the fourth year of your operation (end of the sixth year for horse related activities). Many tax practitioners believe that making this election red flags your return for scrutiny.

If you raise the presumption that your activity is engaged in for profit, the burden of proof shifts to the IRS. The presumption is rebuttable - the IRS can still try to prove that your activity is a "hobby." More importantly, however, a failure to show a profit in three out of five years (or two out of seven years for horse related activities) does not raise the presumption that your activity is a hobby not engaged in for profit. There is a Tax Court case where a horse activity declared losses for over twenty years, but was still found to be I engaged in for profit.

The key question under section 183 is whether you intend to make a profit. In answering this question, the IRS doesn't simply accept your statement that you intend to make a profit. Instead, it examines your conduct to see if it supports your avowed intention.

The regulations to this code section list nine factors to consider in determining whether or not an activity is "engaged in for profit." The nine factors are: (1) the manner in which the taxpayer carries on the activity, (2) the expertise of the taxpayer or his advisors, (3) the time and effort expended in carrying on the activity, (4) the expectation that assets used in the activity may appreciate in value, (5) the taxpayer's success in carrying on other similar or dissimilar activities, (6) the taxpayer's history of income or losses in the activity, (7) the amount of occasional profits, (8) the taxpayer's financial status, and (9) the elements of personal pleasure or recreation. These factors are crucial. Most courts rely on these factors in deciding whether a taxpayer's activity is engaged in for profit.

Not all nine factors exist in every case, nor does the IRS keep score. It's not a matter of whether or not you meet a majority of the nine factors. Instead, the IRS looks at all of the facts and circumstances of your case. With horses, dogs, and other animals, the amount of time you spend with your animals often doesn't count much in favor of showing a profit intent as the IRS tends to think the activities are recreational.

If you're a farmer, you can't necessarily rely on the expectation that the increase in the farm's value will show an overall profit for your activity. The investment in the land and the farming will be considered one activity only if the farming income exceeds the deductions attributable to farming, but not directly attributable to the holding of the land.

The important thing is that if you are claiming losses from a business, you must conduct the activity as a business. Keep accurate records, make budgets and review past operations, have a formal business plan, join business organizations, obtain the necessary business and sales tax permits, and if you're not an expert, consult with someone who is and document your consultations. Documentation is crucial. It's notgood enough to say you make a budget at the beginning of each year, but you don't keep a copy of it.

Ms. Parrish is correct that advertising is important. Businesses advertise, hobbyists don't. If your business is losing money, change your mode of operation, your product mix, or your business plan. The point is that businesses that lose money don't keep doing the same thing. They change in an effort to become profitable.

If despite changes, you can't become profitable, it makes sense to discontinue the activity. Hobbyists, on the other hand, don't change or discontinue their operations because making a profit is not their goal.

This is a complex issue. If you need more information, you should consult with your tax advisor or you can call the IRS at 1-800-829-1040 and request a free copy of Publication 535 Business Expenses.

Sandra R. Bullington is a C.P.A. and a member of the Maryland Bar who has dealt with this issue on a business basis.
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Author:Gullington, Sandra
Publication:Countryside & Small Stock Journal
Date:Mar 1, 1993
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