You’re thinking about starting a new business venture. But, first, you need to learn a little bit about it. And boy, there are a lot of things to do to get ready. You need a website, business cards, logo, maybe a store front, paperwork, accounting software, a business structure…the list goes on and on.
And that’s all before you can even make any money!
But now it’s tax season and your tax preparer wants to know what activities you had for the business.
Check “yes” or “no”. Did you start a new business?
That’s been a long-debated question online for years. The IRS makes it simple for us, though. That’s what we’re going to talk about in today’s blog.
When can you deduct your business expenses?
It doesn’t matter what type of business you have. It could be a real estate fix-n-flip business, an AirBnB business, an online business, a retail storefront, a service industry job or even a new business as a writer.
You’ve got expenses before you get income.
The IRS has a few things they want to see before you can take a deduction for those expenses.
They want to know that:
If you miss even one of those four things, you don’t have legitimate business deductions, at least not this year. All is not lost, though, you may be able to take a deduction later.
Question #1: Have you started this business?
The question isn’t whether you’ve made income yet. The question is whether you’ve actually started a business.
Let’s look at a few examples.
You buy a piece of property to eventually build a 2 family rental on. Meanwhile, the property has expenses like property tax, mortgage interest on the loan and some maintenance on the land to keep it free of weeds and pick up trash.
Are those expenses deductible?
The answer is “it depends.” Have you started this business?
If you don’t have a renter for the land, no income from the land and no way of having income in the foreseeable future, then no You have not started.
That means the property expenses are capitalized until you can begin. At that point expenses will either be deducted as startup expenses or capitalized and depreciated or amortized over a specified length of time.
If you did rent the land out or TRY to rent the land out, you have started. That means you have a deduction.
In this particular case, you have a passive real estate investment which means that you have some other restrictions on losses, depending on your adjusted gross income.
Now, let’s say you’re going to start an online business.
You buy a course on how to run an online business. You hire someone to set up your website. You get a new computer. All in, you spend over $10,000 but you haven’t made any sales yet.
Have you started a business?
Maybe, but there is an additional problem. If you took the course on how to run an online business before you actually set up an online business, then it is an expense preparing your for a new business or profession
In that case, the expense is not deductible.
If instead you started your business first and then took the course to learn how to do it better, then it is deductible.
Do you see the difference?
Start first. Even a baby step is better than no step. You have to start the business first to get the deduction.
For the rest of the expenses, if you’ve got a business started in the year, even if you aren’t yet profitable, you have a deduction.
I’ve started a “Steps to Success” as part of my Facebook group, Diane Kennedy’s US Tax Group. We talk about simple steps you can take right now to start a business in a weekend. There is one big reason why I’m doing this project. I want you to start a business so you pay less tax now and have more money in your pocket immediately. And I want you to start a business so you make money in a few years so you have a tax problem. Now that’s something I can help you with!
Remember, though, that this is just 1 of the 4 necessary tests to get a business deduction.
If you have started your business, you’ve passed #1.
#2. Is it a legitimate business deduction?
The IRS wants to see two things in order for an expense to be deductible. It needs to be “ordinary and necessary” to the production of income.
What’s deductible? It depends!
In this case, it depends on your business. You need to be able to demonstrate, with a straight face, that the particular expenses are ordinary and necessary to your business.
For example, my CPA practice can take a deduction for music that I play in the office. I can’t take a deduction (at least not easily) for movie tickets. But if I had a business writing screenplays, I could take a deduction for movie tickets.
What is your business? And for everything you spend money on, ask yourself, “How can this be deductible?” Track that and discuss it with your CPA.
#3: You (or the business) paid for the expense.
If you’re audited, you need to show that there was a business purpose for the expense (#2) and that it was actually paid for. Preferably, your business paid for it. You could also do it personally, but that could cause you problems down the road because it could be considered commingling.
If you commingle income or expenses between your personal money and your business money, a crafty lawyer who wants to sue you could prove you didn’t really operate your business like a business. Plus, the IRS or your state tax authority might make the same decision. If your business isn’t run like a business, it’s not really a business at all, it’s just a hobby.
And a hobby can’t take any tax deductions.
That’s the warning. Don’t make a habit of commingling business and personal income and expenses between your personal and business funds.
I do want to remind that if nothing else, you can treat payments you made for your business as expenses that you are reimbursed for. Prepare an expense account for the business, just like you did when you were an employee. The company writes you a check.
If you use your credit card to pay for a business expense, it’s also deductible even if you haven’t paid the credit card off yet.
#4: You have a real business and it’s not just a hobby.
The IRS considers 9 factors to when they are deciding whether you have a business or not. Remember the alternative is a hobby and you want to avoid that designation at all costs, especially due to the added burden that the Trump Tax Plan placed on hobbies.
Expenses for your hobby are not deductible, no matter what. In the past, you could take a deduction for the expenses up to the amount of income. You couldn’t create a deductible loss, but at least you could offset the income.
So, for example, if you had income of $100 and $1,000 in expenses, it used to be you had no taxable income. That’s because $100 of the $1,000 in expenses was deducted against the income.
Effective 1/1/2018 with the Trump Tax Plan (Tax Cuts and Jobs Act), you can no longer take a deduction for the income against the expenses if you have a hobby. That means that in this example, you’d have to pay tax on the $100 of income and you’d get no deduction for it.
That’s why it’s so important to make sure you have a real business and not just a hobby. Here are the 9 factors that the IRS watches.
1. How does the taxpayer carry on the activity. You can establish this by maintaining separate personal and business bank accounts, keeping records and books, and acting like similar profitable, operational entities.
2. What is the taxpayer’s expertise. You should have extensive knowledge of your profession or activity, such as showing that you have studied accepted business methods and sought advice from experts. If you don’t have past success, make sure you have a coach, mentor, advisor or consultant who does!
3. Does the taxpayer spend sufficient time and effort in carrying out the activity. In the Audit Technique Guide (ATG) that deals with the hobby versus business question for MLMs (aka direct selling aka multi-level marketing), it’s determined that 2 nights a week and 2 weekends a month shows sufficient time and effort. It’s not engraved in stone, though, so make sure you talk to your tax pro about the time and effort standards you’ll need to meet.
4. Does the taxpayer expect to make money? An expectation that assets used in an activity, such as land, may appreciate in value. Regs. Sec. 1.183-2(b)(4) says such appreciation may be considered in lieu of current profits. This isn’t as easy to prove with some types of businesses, but if it fits – awesome!
This could be a big one for a writer who writes a series that could be considered “evergreen.” In other words, it goes on to provide royalties year after year without any additional work. It is an asset and there is an expectation that such an asset will appreciate in value due to its ongoing passive income stream. Appreciation is also important consideration for real estate investors. Real estate investments frequently provide appreciation.
5. Has the taxpayer been successful in other activities. Even if your activity is currently running at a loss, it may be judged to be for-profit if the taxpayer has been able to convert other activities from unprofitable to profitable in the past, especially ones similar to the current business activity. Again, if you don’t have the past success, make sure the people you listen to and employ do.
6. What is the taxpayer’s history of income or losses from the activity. A long series of losses warrants consideration. Is it ever going to profitable? Past income indicates a for-profit activity.
7. What are the relative amounts of the profits and losses. Regs. Sec. 1.183-2(b)(7) states, “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.” However, the presumption of profit motive in Sec. 183(d) says that if an activity has gross income for three or more of the last five years that exceeds the deductions attributable to the activity, the activity generally is presumed to be for-profit.
This isn’t engraved in stone either. It is possible to have a legitimate business that runs a loss for many years and still is obviously a business. Amazon is a great example in this case.
8. What is the taxpayer’s financial status. If you have other substantial sources of income, that may tend to indicate that the activity is a hobby. However, if you can demonstrate that your current state of employment is tenuous (welcome to 2020 and job insecurity), you have a better chance to prove you’re trying to ramp up a business for the future when or if you may no longer have your job
9. Does the activity provides recreation or involve “personal motives.” This may, together with other factors, indicate a lack of a profit motive. If you’re doing something that is fun, it’s harder to prove it’s a business. It doesn’t mean you can’t enjoy what you’re doing, just remember that’s why the IRS has a tendency to target race cars owners and horse breeders that claim their activities are really businesses.
When you start a business, there are some criteria that you need to use to get the deductions. You need to prove you have the intent to have a profitable business by operating in a businesslike manner, putting the necessary time and effort in and hiring advisors/mentors/consultants/coaches who have past proven successes, if you don’t.
Starting a business IS the best way to pay less tax. But you have to make sure you take the next step by using the right tax strategy and having a properly prepared tax return.
We can help! It starts with a tax consultation with me or by joining the coaching program. For more information, give Richard a call at 888-592-4769 or drop him a note at Richard@USTaxAid.com.