Good morning. Ginger is becoming more and more secure and is now switching between Kubae and me. Yesterday she wouldn’t leave Kubae’s side and today she is constantly under foot – mine to be precise. Fortunately I sit a lot.
There is an interesting tax court Case, Welch, that I discovered in my Monday research. It is all about hobby losses. I will provide a more detailed summary later this week but wanted to share my thoughts on the big thorny issue of small business losses I have faced in my years of public accounting.
Oh, and in case you would like to make a donation, make your check out to the Committee Advising Superior Hobbies (CASH for short). Yes, this is from an old Beverly Hillbilly episode. Ha and you didn’t think accountants had a sense of humor or ever watched bad TV (The Office anyone?).
I have reviewed thousands of individual, partnership and S Corporation returns over the years. I have seen hundreds of potentially troubled hobbies. This is because most had multiple years of losses and the Internal Revenue Code (IRC) provides a safe harbor of 3 years of profitability out of 5.
Most were of the garden variety small business type. An individual had a full-time job and then had a sideline business. Most generated some income but no where near the costs of keeping the business alive. So, the owner plowed additional money into the operation. Sounds familiar?
They never really had business plans and, typically tried to remedy the problem following Einstein’ oft-misquoted definition of insanity “Doing the same thing over and over again while expecting a different result”. Classic madness – but ’tis the spice of life I suppose.
Your tax firm’s role is to guide your decision making, especially when it comes to potential audit-risk areas. Schedule C and Schedule E losses are potentially easy targets for IRS audit – especially when you have 4,5 or 6 straight years of losses and are receiving a substantial W2.
So what is the advice from a mild-mannered, fiscally conservative accountant?
It depends.
Like you didn’t see that coming. But, while each potential hobby-loss business is somewhat unique, each follows similar patterns. The owner finds something they are good at and try to monetize it. They generate a little revenue and then talk to the accountant. The accountant, believing in the client’s dream and hearing the “I don’t want to pay taxes” grumble from the client, starts finding other supporting expenses to write-off. The home office, the internet, driving to the mailbox down the country lane.
So, while your little business is huffing and puffing, chugging up the hill towards profitability, your tax guide is piling more and more weight on you to keep your inertia from getting out of control. Yes, you guessed correctly, most of the expenses that drive the loss are actually not direct costs of being in business.
One Schedule C I reviewed is a great example. Her little business generated $25,000 in revenue. The direct costs were about $15,000, for a $10K gross profit. She lived in Portland and drove to Cannon Beach every weekend to a little craft bazaar. You guessed it, for 4 years straight, we dutifully recorded her mileage and the meals and entertainment (she owned a beach house in town) which generated about $20,000 in additional costs. Voila! Tax loss!
And the possible loss of the safe harbor.
I approached the client manager with a new plan. Let’s cut these expenses in half and call them personal. She ends up with a small profit. Victory I cry!
Not so fast. The client wasn’t pleased with this amazing insight into protecting the losses. After all, no one saw fit to tell her this before. Even after explaining the risk that the IRS can go back to year 1 and deny every year of losses (did you know that?) she wasn’t sold. She was fixated on the $575 in taxes that were due.
Keep in mind that her 5 years of accumulated losses were over $120,000. At her 25% tax bracket, she had sheltered over $30,000 over the years. We were trying to save that $30,000, plus penalties, plus interest, plus plus plus. And the cost was a mere $575.
I know, its hard sometimes to want to pay additional taxes. I hate it as much as everyone else. But, given the choice of paying a little tax or paying a lot of tax, I will choose a little tax every time. Trust your tax advisor when we offer our kernels of tax wisdom.
And really, C.A.S.H. needs you: More importantly I need C.A.S.H. to continue to bring you these excellent little tidbits of hard won knowledge. So donate today! Or you can simply become a client and we both win. Feel free to contact me anytime with questions or if you would like to meet and discuss how ITS can help you and your company increase profitability while minimizing your taxes.
Have an awesome day.
Accounting Clarity 