Starting a business is a big move. It also can pay off at tax time thanks to the many deductions an owner can claim as he or she works to make it a success.
But a businessman or woman better make sure that those tax breaks truly are for a business that's started with the intention of turning a profit.
One business operator didn't convince the IRS or a Tax Court judge of his commitment to making money and he ended up owing $3,955.55 in added taxes.
The core issue before Tax Court Judge Carolyn P. Chiechi was whether Theodore Henderson, Jr., was entitled to deduct $9,854 worth of "other expenses" that he claimed on his Schedule C, Profit or Loss From Business, attachment to his 2007 federal income tax return.
"We hold that he is not," ruled Chiechi.
Questioning business commitment: On his Schedule C, Henderson reported a business loss of $14,027 for THJ & Associates, LLC, his marketing business that he had in addition to his full-time job as an employee at another company.
The bulk of THJ expenses were for what Henderson characterized as training costs related to online course and coaching materials. He also tried to write off travel, meals and lodging expenses, as well as dues, subscriptions, telephone and Internet charges.
"A taxpayer is entitled to deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business," wrote Chiechi.
But in incurring those expenses, noted the judge, "the taxpayer must be involved in the activity with continuity and regularity. A sporadic activity will not qualify as carrying on a trade or business."
Equally important, said Chiechi, is that the "taxpayer's primary purpose for carrying on the activity must be for income or profit."
Basically, what Chiechi told Henderson is don't pretend you're operating a business just to get deductions.
She found that Henderson "failed to carry his burden of showing for his taxable year 2007 that the primary purpose for any activities that he may have undertaken with respect to his claimed THJ marketing business was for income or profit, that he was involved in his claimed THJ marketing business with continuity and regularity, and that his claimed THJ marketing business was a going concern."
That cost Henderson all of his $12,294 "other expenses," $2,440 of which he conceded wouldn't pass Tax Court muster before the judge got involved, and ended up with him owing the IRS almost $4,000 more dollars.
In many cases it can be a wise tax move.
If you are getting decent and regular income from your hobby, you'll be able to legitimately deduct the activity's related costs if you make it a real business.
But as the Tax Court case emphasizes, make sure you operate the converted hobby as a real business.
Two tests: The IRS takes two tests into account when it examines whether an activity is a hobby, where you only deduct a limited amount of expenses as miscellaneous deductions subject to the 2 percent of adjusted gross income threshold, or a business, where you can claim many more costs on Schedule C.
The first is the profit test. As the name indicates, it requires that you show you earned money on the activity in three out of five years.
Even in the best of times, that's not possible for all businesses, so the IRS then examines the factors and circumstance to see if you're truly operating your business in a professional manner. Do you:
- Keep good books and records?
- Devote sufficient time to the enterprise?
- Depend on its income for your livelihood?
- Have the appropriate knowledge and background to make the business a success?
These are just a few of the issues the IRS will take into account. And no one is more important than another; it's a cumulative look at your business attempt.
The bottom line is that you must honestly commit to making your business a success. If you don't, the IRS will determine you're just in it for false tax breaks.
And as Judge Chiechi demonstrated, the Tax Court will likely back up the tax agency.
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