Figuring Out Profitability From Gross Sales And Expenses Taxes Formula The IRS Wants to Know, Are You Running a Business or a Hobby?

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The IRS Wants to Know, Are You Running a Business or a Hobby?

Being a small business owner brings with it a whole host of challenges. Not only are you concerned about taking care of your customer’s needs, getting paid and paying your vendors. You should also be concerned with compliance with federal and state laws as well as local guidelines. Small business owners, especially sole proprietors, are at increased risk of audits. The federal government believes that self-employed individuals are under-reporting their income and over-reporting their expenses. According to the website Tax Help Online, “You know that 20% of all small business audits involve denying a deduction because the IRS reclassifies the small business as a hobby under the so-called ‘hobby loss’ rule.” Internal Revenue Code Section 183 (Activities Engaged for Profit) limits deductions that can be claimed when an activity is not engaged in for profit. IRC 183 is sometimes referred to as the “interest loss rule.” As a small business owner, it is your responsibility to ensure that your business is viewed as a legitimate business in the eyes of the IRS and not a hobby.

Below, I’ve listed some smart business practices that will help you define and grow your business, but also help document that you’re running a real business and 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 has local and online resources to help you.

2) Determine your legal structure (LLC, partnership, C-corporation, S-corporation, sole proprietorship).

3) Obtain an Employee Identification Number (EIN) from the IRS.

4) Open a separate bank account for all your business transactions (deposits and expenses). You need to keep your personal and business transactions separate.

5) Establish a separate line of credit or credit card to use with your business. Put personal expenses on a personal card and business expenses on a business card.

6) Keep your business documents organized. The National Federation of Independent Business recommends keeping business records and receipts for at least seven years.

7) File complete tax returns on time. It will contain all necessary schedules and signatures. Depending on the type of entity you have, you or your CPA will fill out forms such as 1020, 1065, 1040 Schedule C, 1096, 1099, 940 and calculate your self-employment tax. I recommend finding a local Certified Public Accountant (CPA) familiar with your industry to help you determine what forms you need to file and ensure they are submitted on time and to the correct government office.

8) Hire a Support Team: An attorney can help you with your legal structure and a certified public accountant can help you manage your finances as well as keep you in compliance with local, state and federal government.

9) Create industry standard business documents and forms to include: logos, letterhead, business cards, and website.

10) Advertise in your local media with appropriate trade magazines.

According to IRS document, FS-2008-23, below are some questions the IRS may ask when determining whether your business is engaged in a for-profit activity. You need to be prepared to answer these questions and provide documentation.

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 operate as a successful business?

4) Have you made a profit in a similar activity in the past?

5) Will the activity be profitable in a few years?

6) Do you expect the activity to be profitable in the future?

7) Are there elements of personal enjoyment or entertainment?

8) Has your business made a profit in 3 out of the last 5 years?

According to IRC 183, “If your business activity is not carried on for a profit, the allowable deduction cannot exceed the gross receipts for the activity.” The result is that your business deduction will now be an itemized deduction and will be limited to your hobby income.

For more information and assistance to help your company maintain its status as a legitimate business, please contact a local CPA. Each state has its own independent licensing board. If you are located in North Carolina, you can visit the NC CPA Board website and click on their “License Search” button to locate a CPA near you. All licensed and active CPAs in North Carolina will be found on this website.

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