Being a small business owner brings with it a whole host of challenges. Not only are you concerned with taking care of your client’s needs, getting paid and paying your vendors. You also have to be concerned with staying compliant with federal and state laws as well as local guidelines. Small business owners, especially sole proprietors, are at an increased risk of audit. The federal government believes that self-employed people are grossly under-reporting their income and over-reporting their expenses. According to the website Tax Help Online, “You might be shocked to learn that 20% of all small business audits involve disallowing deductions because the IRS reclassifies the small business as a hobby under the so-called ‘hobby loss’ rule.” Internal Revenue Code Section 183 (Activities Not Engaged in For Profit) limits deductions that can be claimed when an activity is not engaged in for profit. IRC 183 is sometimes referred to as the “hobby loss rule”. As a small business owner, it is your responsibility to make sure your business is viewed as a legitimate business in the eyes of the IRS and not a hobby.
Below, I have listed some smart business practices that will not only help you define and grow your business, but will also help you document that you are running a real business and not just performing a hobby.
1) Write a business plan. There are lots of local small business support centers that can help you to put your plan in writing. For example, the Small Business Administration has both local and online resources to assist 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 of your business transactions (deposits and expenses). You need to keep your personal and business transactions separate.
5) Establish a separate line of credit or credit card to use with 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 Business recommends keeping business records and receipts for at least seven years.
7) File completed tax returns on time. This would include all required schedules and signatures. Depending on the type of organization you have, you or your CPA will be filling out forms like 1020, 1065, 1040 Schedule C, 1096, 1099, 940 along with calculating your self-employed tax. I highly recommend finding a local Certified Public Accountant (CPA) that is familiar with your industry to help you determine which forms you will be required to file and making sure they are submitted on time and to the right government office.
8) Hire a support team: A lawyer can help you with your legal structure and a Certified Public Accountant can help you keep your finances in order as well as keeping you compliant with local, state and federal government.
9) Create industry standard business documents and forms to include: logo, letterhead, business cards, and website.
10) Advertise in your local media along with appropriate trade periodicals.
According to IRS document, FS-2008-23, below are some of the questions that 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 knowledge needed to carry on the activity as a successful business?
4) Have you made profit in similar activities in the past?
5) Does the activity make profit in some years?
6) Do you expect the activity to make a 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 activity is not carried on for profit, allowable deductions cannot exceed the gross receipts for the activity.” The result is that your business deductions will now become itemized deductions and be limited to your hobby income.
For more information and assistance in helping your company maintain their position as a legitimate business, please contact an accountant to help you!