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Protect Your Business Losses by Incorporating

How to Fight the Hobby-Loss Rule

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If the net profit figure on your Schedule C is a negative number, you have a business loss. The vast majority of freelancers incur losses. This is how losses work.

First, your business loss reduces your total income. On Form 1040, your total income is calculated on Line 22. The loss also reduces your Adjusted Gross Income (Line 36), and Taxable Income (Line 42). As such, your business loss reduces your income tax. If you have a day job (on a W-2), this means you will get a bigger refund compared to someone who earned the same amount of wages but did not have a freelance gig side business.

Reducing your taxes in this way is an excellent tax strategy. 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. After all, the tax return is just a piece of paper, and so there's no way to tell a legitimate business from a hobby apart except by using a rule of thumb.

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 makes places a huge burden of proof on young businesses. On the one hand, the IRS expects new businesses to incur a loss. 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:

  1. You carry on the activity in a businesslike manner,
  2. The time and effort you put into the activity indicate you intend to make it profitable,
  3. You depend on income from the activity for your livelihood,
  4. Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
  5. You change your methods of operation in an attempt to improve profitability,
  6. You, or your advisors, have the knowledge needed to carry on the activity as a successful business,
  7. You were successful in making a profit in similar activities in the past,
  8. The activity makes a profit in some years, and how much profit it makes, and
  9. You can expect to make a future profit from the appreciation of the assets used in the activity.
This list is found in IRS Publication 535 Business Expenses.

An audit to defend your business losses can be a very expensive audit. If you lose, the IRS will disallow the loss. Your business expenses will be limited only to the extent of business income (which means zero profit). And you will have to re-calculate your tax liability, often meaning that you will have to repay some of your income tax, plus penalties and interest. The audit may also be a waste of time and money, since you will have to spend time fighting the IRS and paying an accountant, instead of focusing on making money.

Nonetheless, defending your business loss is in your best interest, because creative 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 a daily planner showing all this information, it will be harder for the IRS to prove that you were just a hobbyist.

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