Tax Planning with Business LossesBusiness losses offset other income and reduce income tax only. (Since there's no net income, there won't be any self-employment tax on your freelance business.) Accordingly, taxes might be higher in a subsequent year, and so deductions might produce greater tax savings if they can be deferred. Consider using section 179 instead of regular depreciation methods for assets, since section 179 deductions cannot produce a loss or increase a loss, those deductions will carry over to the following year. Consider accelerating freelance income, if possible, into the loss year (again, since this is likely to be a low tax year).
Protecting Business Losses from an IRS AuditReducing your taxes through business losses is an excellent tax strategy, mathematically speaking. In fact, many tax professionals have encouraged people with high incomes to convert their hobbies into "businesses" so they can have a loss to reduce their income. Not surprisingly, the IRS has caught on to this strategy.
There's no hard-and-fast method for distinguishing between a hobby and a real business just based on the tax return. So the IRS has developed a rule of thumb for analyzing business losses: Hobby Loss Rule of Thumb. If a business reports a net profit in at least 3 out of 5 years, it is presumed to be a for-profit business. If a business reports a net loss in more than 2 out of 5 years, it is presumed to be a not-for-profit hobby.
This rule of thumb places a huge burden of proof on newly formed businesses. On the one hand, new businesses often incur losses has assets are purchased and business operations are set up. It is normal for a business to have a year or two of losses before becoming profitable. On the other hand, it is likely that a business could have several years of losses before ever making a profit. In fact, several such cases have been sent to the Tax Court.
If you cannot meet the 3-out-of-5 year rule (3 years of profits in a 5-year period), you can still prove your profit motive using the following nine factors:
- You carry on the activity in a businesslike manner,
- The time and effort you put into the activity indicate you intend to make it profitable,
- You depend on income from the activity for your livelihood,
- Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
- You change your methods of operation in an attempt to improve profitability,
- You, or your advisors, have the knowledge needed to carry on the activity as a successful business,
- You were successful in making a profit in similar activities in the past,
- The activity makes a profit in some years, and how much profit it makes, and
- You can expect to make a future profit from the appreciation of the assets used in the activity.
An audit to defend your business losses involves a thorough review of your income and your expenses for your business. The IRS will examine your accounting records, receipts, invoices and bank statements. The IRS is looking for income that might be unreported or deductions that might be overstated. The IRS may also question whether certain expenses are directly related to your business.
Nonetheless, defending your business loss is in your best interest, because freelance professionals have succeeded in demonstrating a profit motive despite years and years of losses. First and foremost, you must carry on your freelance work in a very businesslike manner. This means keeping good records, keeping a business diary showing meetings with clients, deadlines, and projects, having business cards and a web site that promotes your business, and keeping a log of freelance gigs you apply for, and so forth. If you arrive at your audit armed with all this information, it will be harder for the IRS to prove that you were just a hobbyist. In other words, convincingly demonstrate that you are in business for yourself, and you will succeed in defending your business losses against an IRS examination.