If you’re like most new entrepreneurs, you assume that whatever you start will be called a business. … Consulting ... network marketing … real estate … jewelry making … selling on eBay … you name it.
And because you have a business, you assume you’ll get all the tax benefits that running a business should give you. Right?
Well, maybe not.
You may be sitting in your backyard with a laptop and a beer while your friends are slaving away in their cube farms, but that doesn’t mean that Uncle Sam’s going to call what you’re doing a business and let you write off everything you consider a legitimate expense … tax code compliant or not.
Why?
Because, even if you were promised in whatever seminar you took or package you purchased that you’d be able to live the corporate life and write off hundreds of expenses, the IRS has rules about what constitutes a business … and what you’re doing may or may not measure up. |
Scenario 1: It’s a bright, sunny Monday morning. The alarm goes off and you spring out of bed.
This is the first day of your new life. On Friday you left the corporate world behind; and, when you walked out that door for the last time, you took with you all the knowledge and expertise you’d acquired over the years.
Today you’re a Consultant. You’ve been thinking about this day forever, daydreaming about what it would be like. Now it’s time to start calling the list of people who asked, “Would you ever consider ….?”
You’re sure you’re on your way to building a multiple 6-figure business. Break out the champagne.
Scenario 2: You love woodworking. Over the past 30 years you’ve become a master – creating rockers, turned bowls, lamp bases … you name it. You’ve even taken several commissions for entire dining room sets.
You spend your weekends creating beautiful objects and posting pictures of your work on Pinterest, Snapchat and Facebook. Over the years you’ve made several thousand dollars … enough to cover your costs and put your kids through college.
When anyone asks, you say you have a $15,000 business on the side.
Scenario 3: You’re excited. You just signed up as a network marketing rep and your startup package is on its way. At last, you have a plan for getting on top of those out of control expenses!
Wow … did you see how much those top earners make? You’ll be there in no time. Move over Top Dogs – here you come!
Scenario 4: It’s break time at the seminar. For the last 3 hours you’ve been listening to Experts talk about the different aspects of real estate investing. You’ve been scribbling notes so fast your hand aches … and you can’t wait to get home to tell your other half.
You had no idea so much money is made every day in real estate. And it doesn’t look that hard. If you put your mind to it, shouldn’t take long to flip your first house.
When’s the advanced course?
In each of these scenarios, You, the person involved, assume you’ve got or are getting into a legitimate business and you’re on your way to the time and financial freedom you always dreamed of.
So how do you know if your assumptions are right?
Let’s check out what the IRS thinks and see if your business passes scrutiny.
The IRS wants to see if your business was created with the aim of making a profit. One that they can tax, of course.
So, to determine if you have a business or a hobby, they’ll examine what you do using 9 different factors.
How many tests does your business pass?
Even if you’re a one man show you still need to run your business professionally.
What does that mean?
- It means you may want to create a limited liability company or corporation for your business. Although this isn’t strictly necessary, it does show the IRS that you’re serious about running your business professionally. After all, it took time and money to set up your LLC and it will take more time and money to maintain it.
- If you have an LLC or corporation, it means you keep the company record book (minute book) up-to-date and file any annual documents on time to keep your company in compliance with state law.
- It means you keep proper accounting books – even using basic software rather than spreadsheets.
- It means you keep proper backup documentation – receipts, statements, invoices, banking slips – all filed appropriately after you or your bookkeeper has entered the information into your software and done the reconciliations. No shoeboxes full of crumbled receipts thrown at a poor tax preparer at the last minute.
- It means you set up a separate bank account for the business and you use it strictly to pay business expenses and receive business income. If you want to take money out, you write yourself a check as a draw by the owner – you – against the profits the company makes. No personal purchases with the company debit card!
- And it means you have at least a simple business or marketing plan that you’re following that shows your intention is to make a profit by some date.
To learn more about how to run your business professionally, go to www.bizengaged.com/monthly-membership/ and check out our membership. |
Failing to show that you are the Manager of a professional organization that is run separate and distinct from you, the owner, is a strike against your business … even if you’re a sole proprietor.
Question: Does your business ______PASS or ______FAIL this test?
What is your background in this area? How much training have you taken? What time and effort have you put in to prepare to launch this company?
In scenario 1 you’ve spent several years. In scenario 3 no time at all.
If you don’t have any expertise, are you following someone who has skill and experience in this area? In scenario 4 your coach may have extensive experience that you can tap into.
If you make changes to what the experts are doing, are they thoughtful changes because your business is somehow different?
Question: Does your business ______PASS or ______FAIL this test?
Are you spending several hours a day studying, marketing, trying things, adjusting, working to get better? Or are you working on the business when you think of it?
Have you quit your job or cut back your hours so you can spend time on this business? In scenario 1, consulting is your fulltime focus.
Have you hired other people to help you? Coaches, employees, contractors?
Question: Does your business ______PASS or ______FAIL this test?
This is another way of showing a profit motive.
In scenario 4 real estate would be considered such an asset.
Question: Does your business ______PASS or ______FAIL this test?
Did you do similar work in a corporation for a few years?
In scenario 1 that is definitely the case.
Have you done the same sort of work previously in a different industry?
Question: Does your business ______PASS or ______FAIL this test?
If you have earned a profit consistently the odd loss should not be a problem. This is the case in scenario 2.
However, if you have been in business for a few years and have yet to make a profit, it would be smart to have a business plan that shows you expected this to happen for specific reasons and give the date when you expect to be profitable. This case might apply to scenario 3.
Do you have a good reason why your plan is off-track … downturn in the economy, tornado wiped out your inventory, you had a stroke …?
Question: Does your business ______PASS or ______FAIL this test?
A string of losses with a profitable year here and there doesn’t look like you have a profit motive.
Unfortunately, this is usually the case for scenario 3.
Question: Does your business ______PASS or ______FAIL this test?
Do you need the business to put food on the table like you, the Consultant in Scenario 1? That looks good to the IRS.
If you’re straddling between a job – particularly a well-paying job – and a business on the side, it’s important to have a plan that shows how long you expect to straddle before you jump ship into your business fulltime. This is particularly important for you, the network marketer in Scenario 3.
Question: Does your business ______PASS or ______FAIL this test?
If your business is actually fun – something that you love to do and look forward to – it could count against you. It looks like a hobby. This applies to you, the woodworker in scenario 2, even though you earn $15,000 a year.
Question: Does your business ______PASS or ______FAIL this test?
The thing to remember about the 9 Factor Test is that no one factor is supposed to be more important than any other.
The truth, however, is that factor 1 carries a lot of weight.
The problem with having your business classified as a hobby is that it affects your taxes – big time.
The rules for hobbies state that your expense deductions cannot exceed your hobby income. You cannot post a loss. |
So, if you, our network marketer in scenario 3, make $2,000 your first year but your expenses are $5,000, you get to pay $3,000 out of your pocket with after-tax dollars.
You won’t be able to write off that $3,000 unless you can show proof to the IRS that your opportunity should be classified as a business.
And business alert! The IRS is really tough on network marketers since most never become business professionals.
Let’s say you are the woodworker in scenario 2. You’re retired, and you now spend all your time doing woodworking.
You make $50,000 this year. Your expenses, however, are $75,000. Perhaps you had to buy more expensive equipment to expand your offerings. Your expenses now exceed your income by $25,000.
You’re in a 12% tax bracket. If the IRS classifies your business as a hobby, you need to earn $28,000 more to cover that $25,000 shortfall – the $25,000 in expenses plus $3,000 in taxes - because your write offs were capped at $50,000.
OK, so you can’t take a loss on a hobby. But what happens if you make a profit?
Let’s say you’re in the same 12% tax bracket, but this time you make $75,000 and your expenses are just $50,000. That means you’ve made a $25,000 profit.
Well, this is America. So, while you may have a hard time proving that your woodworking business is a real business … you do enjoy it, after all, so it can’t really be work … you still get taxed on all the profits you make.
The bottom line is this – whether or not what you do qualifies as a business is never a slam dunk.
If you get it wrong, it could cost hundreds, even thousands in taxes that you wouldn’t have to pay if you were classified as a business.
It’s worth spending time to ensure your business can pass the IRS 9 factor test so you can take all the write offs legally possible.
Remember, Judge Learned Hand said:
"Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands." |
To your awesome success,
Wendy Byford
PS. To get more information on business topics for New Entrepreneurs, including videos on this topic, go to www.bizengaged.com/monthly-membership/ and sign up for our bizEngaged Membership. You’ll get the information you need in 10-20-minute videos and interviews, and in our recorded live Q&A sessions.
