Several weeks ago, while searching the Etsy forums, I noticed a comment thread where people were discussing the IRS and how your business could be re-categorized as a hobby if you don’t show a profit for three years. A lot of the businesses on Etsy are run part time, mine included. So I read through this thread wondering if my little business venture could eventually be audited and reclassified as “Hobby” status by the IRS. So far, thanks to my sign and printing sales off Etsy, I have made a small profit each year I’ve been in business until this past year.
Shortly after I found the Etsy forum information I received a newsletter in my inbox from one of my sign vendors. This is a fairly common occurrence, and I usually scan it for interesting topics and what do ya know, there was an article about the IRS categorizing micro businesses as Hobbies. It said that if a sole proprietor files a Schedule C in industries that are usually seen as recreational (like sewing or jewelry making) and the business hasn't made a profit in at least three of the past five consecutive years, the IRS might audit the business and reclassify it as a hobby.
This reclassification could be bad for your business because you could be forced to give up some valuable tax deductions. For example, writing off losses and business expenses against other income, like a day job. Additionally, since the IRS can go back three years in an audit, you may face a really big tax bill as well as the inability to write off losses from your "hobby" in the current tax year and into the future. Thankfully this reclassification is not automatic. If you are selected for an audit, the IRS will typically give you a chance to prove that your intentions are to make a profit and although your business is fun, it is still indeed a legitimate business.
I had my taxes done last week and brought up this topic with my book keeper. She said that the IRS would look into your business status if you did not show a profit for more than 5 consecutive years, but this point could easily be argued. If there is substantial monetary investment in the business, this shows that you have bigger intentions for furthering your venture. Consistent cash flow, even minimal, also offers legitimate proof that you are in fact operating as a business. Most new entrepreneurs start out small with many large expenses to get the ball rolling. These large start up costs, even for home businesses, can eat up any potential profits you may be lucky enough to make in your first several years of operation. For example, I have several items that were purchased in my first and second year of business that need to be deducted over the course of several years (the expected life of the equipment). This adds additional expenses down the road that really aren’t factored as tangible expenses for that particular year, but it shows up none the less.
I'm learning that running a business, no matter how small, is a big job and one that is always changing. Although all of this stuff is a bit daunting, right now I have no intention of jumping off the proverbial wagon, so I guess I better keep up. Below I've listed some other great tips I got from the newsletter article I mentioned above:
-Keep a set of books -- preferably on accounting software or on a spreadsheet.
-Generate profit-and-loss statements and comparative profit-and-loss statements to measure the growth of your business against prior years.
-Chart future projections, and write a plan for turning the business into a profitable enterprise. Keep all your notes and financial statements to present during an audit.
-Be in compliance with local, state and federal requirements by obtaining all required licenses, insurance and permits. Maintain a file of all certificates and licensing information to present during an audit.
-Keep a mileage log or at least an appointment book to substantiate any automobile deductions. Follow the rules for deducting commonly flagged expenses like travel, meals and entertainment.
-Improve your skills. Attend classes, trade shows and conventions. Keep all registration forms and fliers to prove your attendance and the nature of the event.
-Open a separate business bank account. Deposit all sales revenue into this account and pay all business expenses from this account.
-Use your business account for paying business expenses. If you don't have enough sales revenues to cover the expenses, don't start paying business bills from another account. Instead, transfer funds from your personal accounts to cover the bills.
-Advertise. Keep copies of every advertisement you place. During an audit, these records will go a long way toward proving that you're serious about the business.
-Network. Get out there among your peers and exchange ideas. You can do this by joining a local chamber of commerce and other professional organizations.
-Do some thinking. Be ready to explain to the IRS why your business is a serious enterprise. Perhaps you're a stay at home mom trying to bring in more household income while still being there for your kids? And why exactly aren't you showing a profit? If your having trouble getting the hang of things, admit it. It takes awhile to learn all the ins and outs of becoming an entrepreneur.
-Stand your ground. If you're being audited, and you find yourself on the losing end of the argument, stop the audit. Tell the auditor that you need to discuss the matter with a tax professional before you continue. The auditor must honor your request and give you adequate time before resuming the audit.
If you are questioning your continued business status with the IRS, talk to your tax adviser. If you already know all this stuff and do your own taxes, you are a braver and more knowledgeable soul than I – Go You! Either way there are so many rules out there that it can make your head spin. Stay current with updates and if you have questions, research them and don’t be afraid to ask someone in the know.
Aside from the information from the newsletter, this is just my interpretation of of what I've learned so far on this road to becoming an entrepreneur, but all things considered, I am very happy to have been reassured by my tax adviser that my business is not currently in danger of being reclassified, and even if it were, I would have her help in contesting the issue. So, now I feel better, and my refund is on it’s way which is another big ” Yeah!” in my book.
April 15 will be here before you know it!
This is all wonderful advice! I learned a lot of this from my husband who has run small businesses in the past, but I did not know until recently, that the IRS could reclassify your business! In this economy, I do everything that I can to make a profit!!!! Thanks for a wonderful post!
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