Are Sole Proprietorship Audits Going to Rise Again in 2009?


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My tax wire this morning contained a Notice from the IRS regarding a new Fact Sheet on hobby businesses.

The IRS tends to put out Fact Sheets when they’re seeing a problem come up over and over again, or when they’re anticipating a problem with public understanding. Given the subject matter of this Fact Sheet, my guess is that sole proprietorship audits are going to increase again next year.

With our sour economy, people are looking for new sources of income, and starting up a small business has always been a part of that. However, I think a lack of basic business knowledge is going to hurt many people, in some cases more than it helps.

Here’s the text of the IRS’s fact sheet on Hobby Businesses:

The IRS has released a fact sheet to help taxpayers determine whether an activity is engaged in for profit or merely as a hobby. The fact sheet discusses the hobby loss rules and lists several non-inclusive factors to be considered when making this determination, including:

  • 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?

If an activity is not for profit, losses from that activity may not be used to offset other income and deductions cannot exceed the gross receipts from the not for profit activity. Further, hobby deductions are claimed as itemized deductions in the following order and only to the extent stated in each of three categories:

  • Deductions that a taxpayer may claim for certain personal expenses, such as home mortgage interest and taxes, may be taken in full.
  • Deductions that do not result in an adjustment to the basis of property, such as advertising, insurance premiums and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
  • Deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.

Are you the “expert” on your block? If someone were to come to you regarding a new business idea, especially if they had little or no experience in business, where would you tell them to begin?


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