Is a checkbook enough? - Documenting losses on a part-time business

What do Tupperware, Shaklee and Mary Kay have in common? Their products arenÂ’t similar, but they all do business the same way and depend on the average consumer to sell their products. Based on their bottom lines, these companies and others like them have been very successful. Add to these lines of business the doctor who also raises cattle or the professional who makes jewelry in his or her spare time and the similarities become harder to find.
So what might these dissimilar businesses have in common? At tax time, their proprietors need to prove they areÂ…wellÂ….businesses. In some cases, the stakes can be high.

Here’s an example: take the professional who earns a salary of $500,000 but spends $100,000 on a cattle operation. He or she might have sold a few head of cattle this year but more typically took a loss on the operations – and the IRS does not like to see this on a taxpayer’s return.

Then thereÂ’s the carpenter who works for a construction company all day and goes home to knock out a few objects dÂ’art before bedtime. Some might say this is a hobby, but in his mind heÂ’s trying to get a second career going and hoping someday to become another Picasso.

Finally, there are those who get into sales of Tupperware and other products because they like the product and want to earn the starter kit. That might be all they want to do, but they are still selling a product and turning a profit, albeit a small one.

WhatÂ’s wrong with taking a deduction for the losses these self-starters might incur in the pursuit of their dreams? A lot of people might answer nothing. Unfortunately, the Internal Revenue Code is not necessarily formulated that way. If youÂ’re in a similar situation, how you can protect yourself in the event of an audit?

The Rules

Internal Revenue Code Section 183 limits the amount that can be deducted when you are not engaged in an activity for profit. Basically, the deductions are limited to the gross income from the activity. To illustrate this, let’s say you raise cattle in your spare time and you incur $100,000 in expenses, including the cost of the cattle in the activity. Assuming your sales for the year total $50,000, you show a loss of $50,000. If the IRS can show you did not intend to turn a profit on the cattle operation, then your deductions against income are limited to $50,000 – not very favorable to your tax bill. If you can prove the operation is meant to turn a profit, you might be able to deduct the full $100,000 and offset other income by the net $50,000 loss. How will you do that?

You can argue until the cows come home that you planned to make money, but the IRS will look use a nine-factor test to determine whether the business is engaged in for profit. Here is what you will do.

First, you will operate your cattle operation in a businesslike manner. That means keeping adequate records and separating your personal funds from the business funds. ItÂ’s not enough to rely on cancelled checks. In one case, the Tax Court determined that a horse breeder did keep adequate records because he meticulously recorded the horsesÂ’ pedigrees and all of the pertinent expenses and income in a farm record book. On the other hand, the only financial information supporting his deductions were cancelled checks, so the court determined the operation was not run in a businesslike manner.

Second, you will show that you have the expertise to operate a cattle farm profitably. If you donÂ’t have the expertise, find someone who does. In one case, a taxpayer was born and raised on a farm. In denying his loss deduction, the court said the taxpayer did not know how to make a profit from his current farm undertakings and, while he did seek advice about farm concerns, he did not seek advice on how to make a profit at farming.

Third, you will show that you spend substantial time and effort on the cattle operations and that your efforts were designed to enable your operations to make a profit. It is not necessary to spend 40 hours a week on the operation, but you will need to show involvement in the business. Hiring a full-time ranch supervisor to act in your stead would fill the bill. This is very much what the IRS likes to call a facts and circumstances situation. 

The term profit does not necessarily mean that you make money on the activity itself. If, for example, you reasonably expect the investments made in the cattle operation to enhance the value of your land, this could be enough to prove a profit motive. You will need to show that you expect the gain from appreciation in the assetÂ’s value to exceed the annual losses, thereby realizing a net gain over the life of your project.

Your past track record in showing a profit from other activities, whether similar or dissimilar, will also be a factor in determining if you can reasonably be expected to profit from your present operations. In one case, the IRS disallowed the expenses a lawyer incurred in a failed attempt to facilitate the sale of artwork. The court looked to past transactions where the lawyer served in similar capacities and did, indeed, realize a profit. The irony is that those successful transactions were the cause of the IRS investigation in the first place. The court ruled the taxpayer was engaged in the activity with a profit motive.

Your intent to create a profit from your cattle operation can also be shown by the business’ history of profit and loss. In the early years of a start-up venture, losses are to be expected. If your cattle operation turns a profit in three of the last five consecutive years – ending with the tax year in question – the business is considered to be operated with a profit motive (unless otherwise proven by the IRS).

The amount of an occasional profit in relation to losses is also indicative of a profit motive. For example, if you typically incur small losses but occasionally earn significant profits on the sale of cattle to offset those losses, this could indicate that you are engaged in an activity designed to turn a profit.

Your financial status also might be considered relevant to your motives for entering into the cattle farming business. Generally, the less you have, the easier it is to prove you are running a business to produce income for you and your familyÂ’s support.

Finally, is there an element of personal or recreational enjoyment involved? Not the incidental kind that comes from a job well done, but real enjoyment? For example, are you taking your personal boat out for deep sea fishing excursions? Such a situation arose recently and the court found in favor of the IRS.

The Lessons

It is not uncommon for taxpayers to think their business must turn a profit three out of five years to escape hobby loss treatment. The truth is, however, that individual facts and circumstances must be examined to determine if you are likely to be challenged on deducting your business losses. Keeping a checkbook is not enough to stave off an aggressive IRS agent. Give us a call if you have part-time activities that produce losses and letÂ’s find a way to document your actions to prove you are engaged in profit-driven behavior.

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These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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