In today’s miserable job market, millions of Americans are trying to make ends meet by starting small businesses. The first motive for doing so, necessity, is obvious. What is less understood is that a small business, if successful, is probably the greatest single tax shelter under the Internal Revenue Code.
Over the past ten years, the number of small businesses has steadily grown. Of the approximately 25 million companies in the country today, nearly 75 percent of them do not have employees other than the principal owner.
To achieve both stable employment and to enjoy the tax benefits of a business, you need to do it correctly from the beginning and avoid some common, costly mistakes.
Read on to learn more, and pass this on to someone you know who is thinking about taking the plunge into small business – but doesn’t know how to get started.
Today (with the help of acclaimed tax advisor Dan Pilla, a regular contributor to Independent Living), we want to share with you several points on how you, or someone close to you, can benefit from owning a business – even a simple one which is run on the side.
Necessity Forces Millions
to Take the Plunge into Small Business:
Here’s How to Do It Right
Too often people take cash from retirement fund distributions or early retirement buy-out packages and start their “dream” business in a field in which they have no practical experience. For instance, a telecommunication executive decides to open a restaurant from scratch.
This can easily turn into a mistake. There are always curveballs thrown at you in business, even when you’re highly skilled and experienced. But without practical experience or people connections, the curveballs are harder to see coming and more difficult to handle.
Instead, a good rule of thumb when launching a business of your own is to start in an area which is familiar to you. Perhaps, this telecom executive would find more success, and find it sooner, as a telecom consultant or a sales trainer for the telecom industry.
An Overlooked Business Opportunity
Right at Your Fingertips
Nearly everyone has a hobby they could turn into a business. By adopting a few simple changes, the activity can be converted into a legitimate business with substantial legal, financial, and tax advantages. Some advantages available to all businesses, even small ones:
Write off your “previous” hobby expenses such as membership fees, admission to industry events, subscriptions, and the tools or materials needed to enjoy your hobby;
Claim a deduction for a portion of your utilities, taxes, mortgage, or rent using the home-office deduction;
Write off part of your automobile expenses;
Deduct certain travel, meal, and entertainment costs;
Write off your self-paid health insurance premiums;
Put aside much more money in a SEP-IRA or similar business owner retirement plan;
Use business losses against other income, such as from a full-time job, and lower your overall income taxes;
Create and use a business entity, which can help protect your assets and your personal privacy.
This is by no means an exhaustive list. Yet taking a hobby and “going pro” may also help increase the chance of success. You have knowledge of the subject, probably already know some of the top people or resources in the industry, understand the market intimately, and most importantly, you have a passion for it (which will help you persevere through the early bumps in the road).
Can a Hobby Be Turned Into a Business?
Does It Make Sense to Do That?
The quick answer is, yes. Some of the advantages are listed above, however, the key change you must make to turn your hobby into a business is to operate in a “businesslike manner” as defined by the IRS, and to do that you must show evidence of a “profit motive.”
As long as you accomplish this, you’re entitled to claim deductions for all the expenses associated with your new business and use losses to reduce your taxable income.
Internal Revenue Regulation section 1.183-2(b) provides guidance on the elements that the IRS looks at to determine whether a profit motive exists. Some of the key elements are:
Advertising your product or service, which in the Internet Age is cheap and easy to do;
Keeping books and records in a business-like manner to get and keep a handle on your revenues and costs;
Following reasonable business practices to be profitable and control costs;
Already having or working to gain expertise in the area of concern; and,
Spending a reasonable amount of time working in your business.
Do You Need to Show a Profit in Your First Year?
Many people are concerned about starting their own business because they’ve heard horror stories about people who’ve been audited and had the IRS reclassify their business as a “hobby.” In that event, you would be required to pay taxes on all the receipts without the benefit of any expense deductions.
This is a risk if your small business loses money for several consecutive years, because the IRS is more likely to claim your activity is not engaged in for profit.
However, contrary to popular belief, it is important to understand there is no legal provision requiring you to earn a profit in connection with your business in order to take legitimate deductions.
Dan Pilla, guest contributor to Independent Living and tax planning expert, explains:
“It boils down to a question of intent. Did you undertake to earn a profit or did you intend to play and have fun? If the former, you are entitled to the deductions; if the latter, you may not be.” To avoid problems in this area, you need to understand two specific provisions of law.
First, code section 162. Deductions for business expenses are allowed:
There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.
In other words, expenses are deductible if they are “ordinary and necessary” and if incurred while carrying on a “trade or business.”
Second, code section 183, which is the source of the confusion:
In the case of an activity engaged in by an individual or an S corporation, if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed except as provided in this section.
In plain English, when engaged in a trade or business, you may deduct all ordinary and necessary expenses. But if your activity is not engaged in for profit, the related expenses are not generally allowed as deductions. That sounds straightforward until you read section 183(d):
If the gross income derived from an activity for 3 or more of the taxable years in the period of 5 consecutive taxable years exceeds the deductions attributable to such activity… then, unless the Secretary establishes to the contrary, such activity shall be presumed for purposes of this chapter for such taxable year to be an activity engaged in for profit.
Section 183(d) creates a presumption the activity is engaged in for profit if it produces profit in any three of five consecutive years. In that case, all proper deductions are allowed under code section 162.
It’s Important to Look
at What the IRS DOES NOT Say
It does not say, “…if no profit is realized in three of five years, you are not entitled to claim deductions.”
Therefore, if you fail to earn profit in at least three of the five years, the presumption of a profit motive dissolves. But, as long as you have other means of proving a profit motive, you can lose money ten out of ten years and still claim your deductions.
The test in section 162 has nothing to do with whether your business actually earns a profit. The test is whether you engaged in the activity with an honest objective of making a profit.
In fact, the expectation of profit doesn’t need to be reasonable – it doesn’t need to be a smart or savvy business decision. All you need is to demonstrate a good-faith objective of making a profit, and you are entitled to your deductions.
A simple way of doing this would be to spend a few hours writing a business plan. A good way to start is by doing an Internet search for business plan template. Spend as little as an hour or two on this, then print it, sign it, date it and file it. Then simply spend a few minutes each year updating your plan. This brief expenditure of time and effort will go a long way toward documenting your legitimate profit motive.
We hope these points save you some time and money in your quest for financial independence through starting a business. The benefits of a business are available to you and your loved ones whether you’re looking to start a large corporation backed by venture capital or turn a hobby you love into a money machine.