When you’re just starting out, you may have fears of the IRS. Stories abound about taxpayers facing onerous audits or even losing their companies because of tax problems. While it is true that the IRS looks closely at some businesses – especially those dealing primarily in cash because of the temptation to underreport income – there are many misconceptions about the IRS. To alleviate your concerns, let’s set the record straight. Take the follow test to see if your understanding of some tax matters is correct.
If my expenses are greater than my income, I’ll be audited. True or False?
False. This fact alone won’t necessarily trigger an audit. When expenses exceed income, the result is a tax loss reported on a return. There’s no law that says a business must be profitable every year; just look at the number of Fortune 500 companies that report annual losses. So having a loss from time to time is understandable.
Generally you are allowed to claim all ordinary and necessary business expenses, although there are limits or restrictions on some types of expenditures (for example, you can’t deduct most government fines and penalties). Be sure that deductible expenses you claim on your return are supported by records and other documentation, just in case the IRS questions your return. And think about the hobby loss rule, which follows…
If I show losses when I’m starting up my business, I’ll be subject to the hobby loss rule that limits my write-offs. True or False?
False. It’s common to experience losses in the early years of a business but if you are in business to make a profit you’ll be okay. The hobby loss rule says that if you’re not in an activity with a reasonable intent to make a profit, then any losses are deductible only to the extent of business income for the year. Moreover, these deductions are not business deductions – they’re personal miscellaneous deductions, which can be claimed only to the extent that they exceed 2% of adjusted gross income.
If you have losses year after year, the IRS may question whether you have a profit motive. Some businesses take years to get off the ground and this doesn’t mean they are hobbies. The IRS presumes you have a profit motive if you’re profitable in three out of five years (two out of seven years for breeding, showing or racing horses), but if you have more “loss” years, be prepared to show by objective evidence that you have a profit motive. For example, be able to demonstrate that you operate in a businesslike manner, with a business plan and good books and records. The IRS lists these questions to determine a profit motive:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from the activity?
- If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
While not on this list, perhaps the most important question is whether it makes economic sense to continue an activity that is always losing money.
If I claim a home-office deduction, I’ll automatically be audited. True or False?
False. It has been assumed by many home-based business owners that if they take a home-office deduction on their tax return, they’re inviting an IRS audit. This may have been true in the past, but likely it’s no longer the case. The reasons:
- More than half of all businesses in the U.S. are home-based. The IRS isn’t going after all of them.
- The IRS encourages home-office deductions. You can deduct your actual expenses or use an IRS-created simplified method.
The IRS can help me. True or False?
True. While taxpayers may want to deal with the IRS as little as possible, it’s part of the IRS’s mission statement to “provide top quality service by helping [taxpayers] understand and meet their tax responsibilities.” Even if you work with a tax professional, you can find answers to tax questions for free from the IRS and save on professional fees.
- Access information online. IRS.gov offers a wealth of information for small-business owners and self-employed individuals. Start at the Small Business and Self-Employed Tax Center for links to information and resources.
- Attend webinars. The IRS sponsors webinars from time to time on various topics of interest to small-business owners. For example, there’s one archived on tip reporting and tips versus service charges that is helpful to restaurant and tavern owners.
- Call the IRS. If you have a specific question, there is a special toll-free number for businesses: 800-829-4933.
How did you score? It’s important for small-business owners to take their tax responsibilities, and the IRS, seriously. However, there’s no need to be afraid of the latter if you’re dealing correctly with the former.
This information is provided for informational purposes, may not be applicable to all situations, and is not intended to provided legal, tax, or financial advice. For specific advice about your unique circumstances, you may wish to consult a qualified professional.