9 Factors Determining Profit Motive

Profit or Hobby?

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You all must know the standard rule for business- be profitable.  Any business that can’t cover its costs is not long for this world.  Even a non-profit entity can not spend more than it takes in for very long.

Moreover, the government amplifies this standard rule of thumb for a business- a business must make a profit at least three years of every five.  Whose rule is that?  The IRS’.   Because if you don’t meet that standard, the IRS has every right (obligation?) to term your baby a hobby.  That means no deductions for what you thought were valid business expenses.

And, as I have explained to more than scores of business owners and managers, the IRS can also shut down a business that does not maintain meticulous records.  Those shoeboxes of receipts do NOT qualify as meticulous records, either.

So, what happens if the IRS deems your business to be a hobby?  You will have to pay taxes (income AND social security AND Medicare)  on any money you take in- unless you have BUSINESS records to substantiate the claims that the expenses were valid business expenses for your hobby. You, however, can not deduct one penny more for your expenses than you earned in income.

Yes, I know that sounds bizarre- you need business records to substantiate the expenses for your hobby.  Bizarre or not- those are the rules.

Now, there are some exceptions to this classification.  And, the exceptions revolve about proof that there is a true and bona fide intent to create a profit. The box below stipulates the nine (9) factors that determine profit motive(per government regulations).

9 Factors Determining Profit Motive

But, if you fail to have adequate records, the IRS is allowed to impose a 20% penalty on tax obligations due.  Why?  Because failing to keep adequate books and records is considered to be negligence.

And, this was just affirmed by a new Tax Court case.  Amy started a hair-braiding business around 2003.  She didn’t operate in her home, but rented space in a shopping mall.  (This is a critical factor in proving business intent, by the way).  She advertised (in the Yellow Book), created brochures and advertising, and maintained a website.   And, while she did have a business banking relationship, she eventually closed the account as her resources dwindled to save her remaining cash.

Around 2011, Amy took on a full-time employee position, but still worked weekends in the salon, hoping to deal with walk-in customers and appointments.  But, she only managed to serve about a dozen clients- and closed the business in 2012.

Of course, you must have figured out that Amy never generated a profit from her business.  As a matter of fact, in 2011, she grossed the meager total of  $ 325 with more than $ 16K in expenses. (Rent was the bulk of the cost at $ 13K, but phone/internet costs were almost $ 2K additional.)  And, the IRS rejected the loss on Amy’s tax submissions.

Delia v Tax Commissioner 2016

However, the US Tax Court agreed with Amy. (Delia v. Comm’r, T.C. Memo. 2016-71)  It determined she did have a profit motive and took the proper steps to attain profitability- even though she failed to achieve that milestone.  BUT- it also determined she was guilty of negligence in preparing her 2011 tax return.  Because she lacked adequate documentation, proper handling of records, and proper tax analysis.  (You guessed it- Amy didn’t use the Adjuvancy for the required financial services. smileyface )   So, the Tax Court nailed her with the 20% penalty.

Amy must have figured, “You win some, you lose some.”   We figure you need to use our services.

 

 

By the way, I am NOT discussing the ridiculous superstitions that revolve about the ‘special circumstances’ that obtain today.  I’ve done that many times before. 

Happy Triskadekaphobia!

 

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