Being a small business owner brings with it a host of challenges. He is not only concerned with meeting the needs of his client, charging and paying his suppliers. You also need to be concerned about complying with federal and state laws, as well as local guidelines. Small business owners, especially sole proprietors, are at higher audit risk. The federal government believes that self-employed people are grossly underreporting their income and overstating their expenses. According to the Tax Help Online website, “You may be surprised to learn that 20% of all small business audits involve voiding deductions because the IRS reclassifies small business as a hobby under the so-called ‘loss of income’ rule.” hobby'”. Section 183 of the Internal Revenue Code (Activities Not Conducted for Profit) limits the deductions that can be claimed when an activity is conducted not for profit. IRC 183 is sometimes called the “hobby loss rule”. As a small business owner, it is your responsibility to ensure that your business is viewed as a legitimate business in the eyes of the IRS and not as a hobby.
Below I’ve listed some smart business practices that will not only help you define and grow your business, but will also help you document that you’re running a real business and not just pursuing a hobby.
1) Write a business plan. There are many local small business support centers that can help you put your plan in writing. For example, the Small Business Administration has local and online resources to help you.
2) Determine your legal structure (LLC, Partnership, C Corporation, S Corporation, Sole Proprietor).
3) Obtain an Employee Identification Number (EIN) from the IRS.
4) Open a separate bank account for all your business transactions (deposits and expenses). You must keep your personal and business transactions separate.
5) Establish a separate line of credit or credit card to use for your business. Put personal expenses on a personal card and put business expenses on a business card.
6) Keep your business documents organized. The National Federation of Independent Businesses recommends keeping business records and receipts for at least seven years.
7) File complete tax returns on time. This would include all required attachments and signatures. Depending on the type of organization you have, you or your CPA will complete forms such as 1020, 1065, 1040 Schedule C, 1096, 1099, 940 along with calculating your self-employment tax. I recommend finding a local Certified Public Accountant (CPA) who is familiar with your industry to help you determine which forms you will need to file and ensure they are submitted on time and to the correct government office.
8) Hire a support team – An attorney can help you with your legal structure and a Certified Public Accountant can help you keep your finances in order and comply with local, state and federal government.
9) Create industry standard business documents and forms including: logo, letterhead, business cards and website.
10) Advertise in the local media along with the corresponding trade publications.
According to IRS document FS-2008-23, below are some of the questions the IRS may ask when determining if your business is engaged in for-profit activity. You will need to be prepared to answer these questions and provide documentation.
1) How many hours a week do you work in the business?
2) Do you depend on income from this activity to pay your bills?
3) Do you have the necessary knowledge to carry out the activity as a successful business?
4) Have you made a profit from similar activities in the past?
5) Does the activity generate profits in some years?
6) Do you expect the activity to generate profit in the future?
7) Are there elements of personal pleasure or recreation?
8) Has your business made a profit in 3 of the last 5 years?
According to IRC 183, “If your business is not conducted for profit, allowable deductions cannot exceed the gross receipts from the business.” The result is that your business deductions will now be converted to itemized deductions and limited to your hobby income.
For more information and assistance to help your business maintain its standing as a legitimate business, contact a local CPA. Each state has its own independent licensing board. If you are in North Carolina, you can contact the NC CPA Board website and click on the “License Search” button to locate a CPA near you. All licensed and active CPAs in North Carolina will be listed on this website.