Hobby Loss and IRS?

[quiltmonkey]

Just curious about those of you in the business; how many years in the biz and during that time did you have losses or profit; if any of you have been hit by the IRS with a "hobby loss" situation? I found a good article on About.com regarding this topic (link is below at the bottom) and I quoted some from that site.

I've been in the biz (2010 will be year #3 for me) and I have a CPA doing my taxes; I am legit; I have a business license, Federal ID, etc.... I am a Sole Proprietor with S Corp. Last year (2009) my CPA said I was just $300 shy of showing a profit. I am a part time quilter so I am trying...!!! This year I have kept expenses down but... not sure what the final outcome will be for 2010. I will say that since married in 1992, DH and I W4 forms are single with zero so they take out the max, and we are in the 28% tax bracket so these past few years (since starting the biz) we have recieved a big tax return check - probably has to do with the business expenses and write offs.... (which is a nice change from the past when we always seemed to pay in more or got a tiny tax return check) So... not to be nosey with anything ..really!... I was curious and any feedback or advice you have I am interested to hear your perspective. I guess my fear is, I have worked my FANNY OFF to make a profit (well not really...the fanny is still there) and I don't want to get audited by the IRS and have to pay back! Has this ever happened to you? Am I worrying my fanny off (uhh not really, see note above) about something I should not be overly concerned?

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 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 places a huge burden of proof on newly formed 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.

http://taxes.about.com/od/taxplanning/a/freelance_5.htm

http://taxes.about.com/od/taxplanning/a/freelance_5.htm

[Stagecl]

Shana,

I haven't been in business for about 3 years now. I am glad I don't have to worry stuff like this. I can't figure out half the things the IRS is doing so my DH and accountant handle it. I did work my fanny off (and it is still there like yours...LOL:P) and glad I don't quilt for others any more.

[quiltmonkey]

Originally posted by Stagecl

....I can't figure out half the things the IRS is doing...

I hear ya sister! Seems like the IRS is always changing the rules or making up new ones. Oh well, it keeps the tax lawyers and CPAs continually on their toes! ...

[MarieBrewer]

In this day and age, considering the economy, I don't know how the IRS can dictate that you SHALL be profitible. When's the last time an airline made any $? I think I lose money every year. Not sure how the IQ will be portioned out-7 years or all this year. I guess that will be determined by my bottom line. Considering the amount of $ I take in, I don't know why the IRS would consider me a not-for-profit hobby. I've never had a hobby with an income well over $10K. My expenses are considerable because I like to buy thread, batting and fabric. Could be drinking, I guess.

[Zora]

You can control your profitability by controlling your write-offs. You are not obligated to declare all of your expenses...just all of your income. You don't have to write off part of your home's electric bill, depreciate the part of your home you use for your business, etc., if you are concerned about the loss created by the deduction of those items.

Yes, your "business" is more likely to be considered a hobby if you are not engaged in it full-time. Worse case scenario, your deductions will be limited to those you can take on itemized deductions (Schedule A) and will be limited to the income you produce. So, if you have $2000 income for the year, you will be allowed $2000 of expenses and will not be able to create a loss. It is a miscellaneous deduction, and probably has limitations.

Just something to think about when doing your return.

[Gator]

I'm not a CPA but after 3 years of loss my tax preparer had me incorporate the business. It costs around 100.00 per year and falls under different tax laws but I can merge the business items with our regular return somehow. They explained it to me but I can't explain it here, maybe someone else can. I have the same worries that you have

Shana. I work full time during the day and quilt/embroidery evening and weekends. Lately, I've been hitting the couch more.

[Kueser]

The changes in your refunds probably have more to do with the changes in tax law that have been put in place in the more recent years to stimulate the economy. Also, don't blame the IRS for the changes, Congress writes the laws, the IRS just tries to make it understandable for the regular guy. I confess, I'm a former Fed and worked for the IRS for 32 years. Shana, as long as you are doing at least 16 hours a week, and making an effort to keep your expenses in line with the income, I don't think you'll run into that much trouble. Just depends on what the computer kicks out (most audits are computer identified). My thought, the economy is running too slow right now for anyone to be making $$$ hand over fist.

[quiltmonkey]

Originally posted by Zora

You can control your profitability by controlling your write-offs. You are not obligated to declare all of your expenses...just all of your income. Just something to think about when doing your return.

Lynn, thanks for that advice. I will mention this to my CPA. I have kept my expenses down this year, so hopefully that will help.

Originally posted by Gator

I'm not a CPA but after 3 years of loss my tax preparer had me incorporate the business. It costs around 100.00 per year and falls under different tax laws but I can merge the business items with our regular return somehow.

Thanks, Connie. This might be an LLC? My CPA was talking about switching me over from an S Corp to an LLC in a year or so... I'll check with her.

Originally posted by Kueser

....Shana, as long as you are doing at least 16 hours a week, and making an effort to keep your expenses in line with the income, I don't think you'll run into that much trouble.

Thanks, Cee. I am usually quilting in evenings and weekends so most definitely have 16 hours per week in that litttle side biz of mine. I average between 3 to 5 quilts per month? I have made an effort to really watch my expenses, and trying hard to get lots of quilts done. Gotta finish entering in all of my data into Quickbooks to find out the final numbers for 2010. Wish me luck! Thanks again everyone for your excellent advice. You are terrific!

[ffq-lar]

Hi Shana,

I think what you and your CPA want to look at is Zora's wise advice--You can control your profitability by controlling your write-offs. It isn't necessary to claim all and every deduction you have. Depreciation of equipment can span seven years, don't claim every bit of your mileage, your business side of utilities at your home, etc.

If you NEED to show a profit, have your CPA help in achieving that. It isn't deceptive, in fact you will owe some amount. Don't let your business flounder when you are trying so hard!!

Home businesses are everywhere--people are trying to make ends meet. And when a friend was audited because of some issues with their "real jobs", the IRS ended up writing them a check for $175 for some things they missed. All that strict rules manage to do is drive businesses under the radar and then the government gets zip.

[TAQuilts]

My CPA pretty much said the same as Zora and Linda above...how to controll your write-offs. He also said I needed to make sure my Business Permits and Ins didn't expire and that I did some form of Advertising said this was key to showing the IRS that I was in this for a Business and not hobby.

I'm not going to write off any home related or travel expenses until after I retire and I can quilt more, and I'll need more expenses to off-set the added income.

Terry

[quiltmonkey]

Originally posted by TAQuilts

...I'm not going to write off any home related expenses until after I retire and I can quilt more, and I'll need more expenses to off-set the added income. Terry

Thanks, Terry, I will follow your advice.

Originally posted by ffq-lar

.......Don't let your business flounder when you are trying so hard!!......

Thank You Linda. I have been really freaking out about this having my doubts I was ever going to make a profit doing this part time... I had a melt down the other day thinking I was busting my tail (every spare moment I have) for all this time and effort, and thinking I made a huge mistake ... and that the IRS was gonna nail me with a hobby loss and then all of this investment of money, time, labor, hard work and effort I've put into this business these past three years would be in vain. I really was bumming out big time.

You all gave me light at the end of the tunnel. I think I will have a nice Christmas, now, and won't worry so much about this hobby loss. Well dang it! It isn't a HOBBY I have been working SOOOOOOOOOOOO hard on this business and neglecting my home life - every spare second I had was quilting and it felt like a ball and chain; it was really depressing me thinking I had to work work work to make money money money or the IRS would get me for hobby loss. My husband (who is a very patient and understanding person) was starting to get mad at me because all of my evenings and weekends were quilting. I was really regretting it...not having any fun with my family or doing my wifely chores. I actually look forward to scrubbing a toilet and vacuuming for a change. Not dusting, though. I hate dusting.

Thanks for clearing up my doubts. I am forever grateful to you all...

[ffq-lar]

I am so sorry you have been stressing about this!!

No more worries. No more stress. Set aside time for YOU and your sweet DH.

Working the long hours you do makes it so hard to balance the time you have left over.

The thought that you, who cares so much for others, is unhappy and that it is affecting your home life--that breaks my heart!!

I wish you a merry and stress-free Christmas Shana. Love you.

[quiltmonkey]

Oh thank you sweet Linda. You always have the best words and know how to say the right thing and it goes straight to my heart. I love you, my sister.

[Quilting Heidi]

Shana,

I know exactly how you feel! It has been a struggle and you and I are in the same year with our business. I've had a consistant year this year but have struggled since Oct. when my mother got hit. Trying to fit quilting in with a mother that needed me and a MIL demanding all my free time has just about pushed me over the edge! I haven't done the numbers and have no idea where I stand but I can say that I did more business this year than I did last year. I too have tried to keep my expenses down and will not be claiming all my travel related expenses. Mostly just thread and such. I hope that does the trick. If it is a loss then it is a loss and there isn't much I can do about it. I stopped doing quilts just after Thanksgiving because I just couldn't fit anymore in with the holidays and my day job. Hopefully us honest people won't get penalized. My head always spins three or four times when I think about all those folks out there that milk the system for years and years and get away with it. Like you, I've really pushed myself and quilted when I didn't feel like it and was exhausted. Sometimes I second guess my decision to go into business. I would have gotten my machine regardless and really had never planned on going into business. I figure I'll give it to mid year and decide whether or not to continue with the business end of it. Try not to stress yourself out over this! It will all work out!

[Bekah]

Shana reading this thread and your comments is like looking into my own life. I work, come home and am in the studio until late, all weekends and my hubby is not a happy camper and I am not making a lot. I have started to build a good customer base but am doing a lot of really small quilts that are the basic charge. I have quilts scheduled for January that will bring in some money, but I am in to year 4 and have not made any profit yet because I listed every little thing I could for deduction. so this year I think I might not claim anything just so I hopefully make a profit of some kind. I am glad you brought this to our attention.

Please relax and have a wonderful Christmas with your wonderful husband. Stressing out over this will not make any of us any healthier.

You are such a talented quilter that I cannot imagine you not doing this as a business. It will all work out, after all we have a Someone who watches over all of us, even in our business.

[mrmquilt]

Shana, One thing I don't think was mentioned above is the amount of profit for your business. According to my tax lady as long as you make$1.00 in profit ,the IRS considered a PROFIT.

Don't know if that helps any.

Michele

[quiltmonkey]

Thanks everyone for your kindness. It means a lot to me.

Let me make it clear: I do not plan on quitting this business. No way. Quitting is an easy way out and not the solution I had planned nor will I do that. I have way too much $$, materials, training and time invested, I have a good customer base. I was just getting worried if I would ever see a profit, being I do this part time. Now I know I can manage this with the suggestions listed above. I actually had a booming business this year! I am really hoping with all of my time spent quilting this year I show a profit, even if it's $1.00 I will be happy. I make plenty of money in my full time job so this side business is to get me set up and established when I retire (hopefully at age 55 or so??? that's just 8 short years from now) and then maybe I can do this quilting biz full time. That's the plan anyway.

[LFQuilts]

Shana and responders,

Thanks for this post. I'm 1.25 years into my small business and have all of the concerns Shana raised. I appreciate the various responses.

Lynn

[Sandra Darlington]

I just started my business in April 2010, but I have all the same worries and concerns. I know I have time before I have to show a profit, but from where I am this first year, wow, am I in the hole!

Cheer up, Shana. I'm sending you some (((HUGS))) my friend.

[quiltmonkey]

Originally posted by sandradarlington

Cheer up, Shana. I'm sending you some (((HUGS))) my friend.

You just made my day. Thank you Sandy.

PS: You've been in my thoughts often. You are and will always be a special friend to me. xoxoxoxoxoxoxoxo

[Sandra Darlington]

Shana,

I've been thinking about you, too. I really thought I would get up for the Iditarod this March. I especially wanted to see the end of the race and hoped to see Clara Austin and pay my respects in person. I would think there will be a special tribute to Jerry that I wanted to witness. I thought I would try to fly to Fairbanks either before or after going to Nome so I could visit with you, too.

But, there is good news and bad news story. The bad news is that I have to miss this year again. The good news is that my daughter is due the end of February, which is why I want to be close to Philadelphia.

One of these years I will get back up to visit you again.

Merry Christmas, my friend. And, please wish Andre a very Happy Christmas, too.

Sandy