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One of the advantages of owning a home-based business is the ability to deduct expenses that would otherwise be non-deductible for federal income tax purposes. However, you should and must be conducting the business in a business-like manner with the intent of making a profit. Otherwise, the IRS might disallow your home-based business deductions and your hobby may cost more than you know. You cannot conduct your business in such a way for the purpose of merely producing “write-offs” for tax purposes. Not only is that unethical, it is illegal. If you are the typical home-based business owner, you likely run your business in an ethical manner with an intent of making a profit. You might think that the phrase “intent of making a profit” is self-explanatory, but the determination as to the profit intent of one’s business is often more subjective than objective. Therefore, in the event of an audit, the IRS uses nine relevant factors to determine whether or not your business qualifies for home-based business tax deductions. Review these factors and consider whether your home-based business is in compliance. You may find areas in the conduct of your home-based business which need improvement.
According to the IRS website, whether or not an activity is presumed to be operated for profit requires an analysis of the facts and circumstances of each case. Deciding whether a taxpayer operates an activity with an actual and honest profit motive typically involves applying the nine non-exclusive factors contained in Treasury Reg. Sec. 1.183-2(b). Those factors are:
1. The manner in which the taxpayer carried on the activity – The fact that the taxpayer carries on the activity in a businesslike manner and maintains complete and accurate books and records may indicate that the activity is engaged in for profit. Similarly, where an activity is carried on in a manner substantially similar to other activities of the same nature which are profitable, a profit motive may be indicated. A change of operating methods, adoption of new techniques or abandonment of unprofitable methods in a manner consistent with an intent to improve profitability may also indicate a profit motive. Your hobby may cost more than you know if you’re not conducting it in a businesslike manner. [Treas. Reg. Sec. 1.183-2(b)(1)]
2. The expertise of the taxpayer or his or her advisors – Preparation for the activity by extensive study of its accepted business, economic, and scientific practices, or consultation with those who are expert therein, may indicate that the taxpayer has a profit motive where the taxpayer carries on the activity in accordance with such practices. Where a taxpayer has such preparation or procures such expert advice, but does not carry on the activity in accordance with such practices, a lack of intent to derive profit may be indicated unless it appears that the taxpayer is attempting to develop new or superior techniques which may result in profits from the activity. Attending and documenting company training would be an example. [Treas. Reg. Sec. 1.183-2(b)(2)]
3. The time and effort expended by the taxpayer in carrying on the activity – The fact that the taxpayer devotes much of his personal time and effort to carrying on an activity, particularly if the activity does not have substantial personal or recreational aspects, may indicate an intention to derive a profit. A taxpayer’s withdrawal from another occupation to devote most of his energies to the activity may also be evidence that the activity is engaged in for profit. The fact that the taxpayer devotes a limited amount of time to an activity does not necessarily indicate a lack of profit motive where the taxpayer employs competent and qualified persons to carry on such activity. The key here is to work your business on a regular and consistent basis. Working your business one hour a day, five days a week would be indicative of a regular and consistent basis. Document this by noting your activities in your calendar or day planner. [Treas. Reg. Sec. 1.183-2(b)(3)]
4. The expectation that the assets used in the activity may appreciate in value – The term “profit” encompasses appreciation in the value of assets, such as land, used in the activity. Thus, the taxpayer may intend to derive a profit from the operation of the activity, and may also intend that, even if no profit from current operations is derived, an overall profit will result when appreciation in the value of land used in the activity is realized since income from the activity together with the appreciation of land will exceed expenses of operation. [Treas. Reg. Sec. 1.183-2(b)(4)]
5. The success of the taxpayer in carrying on other similar or dissimilar activities – The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he is engaged in the present activity for profit, even though the activity is presently unprofitable. [Treas. Reg. Sec. 1.183-2(b)(5)]
6. The taxpayer’s history of income or loss with respect to the activity – A series of losses during the initial or start-up stage of an activity may not necessarily be an indication that the activity is not engaged in for profit. However, where losses continue to be sustained beyond the period which customarily is necessary to bring the operation to profitable status such continued losses, if not explainable, as due to customary business risks or reverses, may be indicative that the activity is not being engaged in for profit. If losses are sustained because of unforeseen or fortuitous circumstances which are beyond the control of the taxpayer, such as drought, disease, fire, theft, weather damages, other involuntary conversions, or depressed market conditions, such losses would not be an indication that the activity is not engaged in for profit. A series of years in which net income was realized would of course be strong evidence that the activity is engaged in for profit. [Treas. Reg. Sec. 1.183-2(b)(6)]
7. The amount of occasional profits, if any, which are earned – The amount of profits in relation to the amount of losses incurred, and in relation to the amount of the taxpayer’s investment and the value of the assets used in the activity, may provide useful criteria in determining the taxpayer’s intent. An occasional small profit from an activity generating large losses, or from an activity in which the taxpayer has made a large investment, would not generally be determinative that the activity is engaged in for profit. However, substantial profit, though only occasional, would generally be indicative that an activity is engaged in for profit, where the investment or losses are comparatively small. Moreover, an opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit even though losses or only occasional small profits are actually generated. [Treas. Reg. Sec. 1.183-2(b)(7)]
8. The financial status of the taxpayer – The fact that the taxpayer does not have substantial income or capital from sources other than the activity may indicate that an activity is engaged in for profit. Substantial income from sources other than the activity (particularly if the losses from the activity generate substantial tax benefits) may indicate that the activity is not engaged in for profit especially if there are personal or recreational elements involved. [Treas. Reg. Sec. 1.183-2(b)(8)]
9. Elements of personal pleasure or recreation – The presence of personal motives in carrying on of an activity may indicate that the activity is not engaged in for profit, especially where there are recreational or personal elements involved. On the other hand, a profit motive may be indicated where an activity lacks any appeal other than profit. Your hobby may cost more than you know if the activity involves mainly personal pleasure or recreation. [Treas. Reg. Sec. 1.183-2(b)(9)]
Additionally, no single factor controls, other factors may be considered, and the mere fact that the number of factors indicating the lack of a profit intent exceeds the number indicating the presence of a profit intent (or vice versa) is not conclusive. For example, if five factors say the activity is not for profit, but four are on the profit side, the activity still could be determined to be engaged in for profit. More weight is given by the courts to objective facts than to the taxpayer’s statement of his or her intent. (Reference: Dreicer v. Comr., 78 T.C. 642 (1982)).
As you can see, there is not a single indicator of the existence of an intent to make a profit or the lack thereof. If you need assistance with determining whether or not your deductions related to your home-based business activity might be questioned in an audit, you should consult the advice of a professional.
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