So despite the warnings we discussed in part II, your business has lost money in more than the allowed two out of five years. In fact, you showed a loss in all five of those years. Are you doomed to have your business labeled a hobby and lose all the tax advantages of the losses you have taken? Not necessarily.
While the IRS relies pretty heavily on their profitability test and the seven other tests we discussed in part II, it is possible to not meet them and still keep your business label. Here are four steps you can take to offset the traditional IRS business standards.
1. Create a business plan with five to ten years of projections- One of the best ways to overcome a failed profitability test is to have a clearly written business plan with five to ten years of profit projections. The key here is to make sure those projections show an overall profit by the end of the projected years. The IRS won’t consider it a business if your own projections show it will never make a profit.
2. Conduct the activities in a business like manner- If you want the IRS to consider your activities a business, you better be treating it like a business. This means you keep accurate and organized records instead of a shoe box full of receipts. It means you have separate bank accounts for the business and your personal accounts. It means seeking out advice from experts in your industry to try and turn a profit. If your business happens to be something that many people also do as a hobby, such as stamp collecting or writing, this standard is even more important.
3. Actively making efforts to improve profits- If you are losing money year after year and making no effort to change the results, you have no hope of the IRS reconsidering their hobby label. Businesses who fail to meet the profitability test should be doing everything possible to show they are trying to turn a profit. This could mean seeking out industry experts, changing marketing strategies or any other measures that could turn the fortunes of the business.
4. Calling your activities a business- You would be amazed at the number of people who doom themselves by calling their activities a hobby to their CPA, an IRS agent or even publicly in interviews. If you want the IRS to consider your activity a business you better be calling it a business yourself. This one may seem like common sense, but you never know when a comment you made about how you don’t care if your business makes money because you get a tax write-off on the losses will come back to bite you.
If you follow these four steps, you will likely be able to convince the IRS your activities that have lost money for several years are still a business. But it should be noted that most of these things must be done before the IRS questions the intent of your business. If you wait until you are holding the notice in your hands, it is probably too late.
The tax value of keeping a business that operates at a loss from being labeled a hobby is extremely high. Take the time now to make sure you are covered in the event the IRS questions your business.