Business Loss 3/5 Years

[Donanita]

I have a client that is in the catering business and this is their 3rd yr of losses.The losses are created by the food purchased for resale and that is not sold. Health state laws prevent reuse of food as food is prepared for sale at festivals and cart sales.Does anyone have clients like this were they do have a legit loss each year and if so have they had any audits from the IRS.

[jainen]

solid logic

3/5 years is more like a guideline, but it is based on solid logic. If they can't make a profit, why do they keep doing it unless they have a non-profit motive? Don't wait for an audit. Document the changes they have been making, such as new products, revised pricing and marketing, enhanced procedures for buying and handling food, professional training and assistance, etc.

Festival work could certainly be subject to hobby loss rules.

[oceanlovin'ea]

Business plan

One thing that they need to have is a written business plan outlining their objectives and plans for the business to be profitable. Sometimes the business loss is caused by depreciation deductions or mileage deductions. Which would mean that they are making money at their business.

I agree that the 3 out of 5 year rule is not hard and fast. But that should be their motive.

Especially if that is there only income you really couldn't call it a hobby.

Linda

[JG EA]

Gross income.

Could part of the problem be not taking out personal use from cost of goods. If they over buy and can't use the food again do they use it themselves? Normally this would be a small amount, but maybe some of their food is given away or routinely used personally.

Is the gross income OK? (Gross receipts minus COG) If it is a loss or very small then they do not have a business but a hobby unless they are in the first couple of years making a name for themselves.

The thing I find most upsetting about client's "hobby" is that you can't (as far as my research has gone) count COG on line 21. It seems you have to include COG with operating expenses, up to the income, on Sch A 2%. This seems very hard. I know some crafts can be capital gain, but what about this - catering. Claim all the income and not take into consideration the cost of the food? Very hard. Which is one of the reasons it is hard sometimes to talk people out of a business and into what it really is, a hobby.

[Donanita]

Not a hobby

Client is in the business of cooking and selling crawfish wich is seasonal to begin with and the cooked crawfish can't be used if not sold.If you have ever eaten crawfish you'll know why.They have a cooking trailer which they use at the festivals and also rent a small lot for during the week.The sales is around $18000 and the food for resale runs around $20000 and this is before the sale tax,.permits,and other expenses are taken.They really are in it to make a profit and the work they do is not easy.They cook the crawfish based on the projected sales and if sales are down then they have food leftover that a small amt can be pulled out as personal but not enough to make a difference.
Just wondering how the restaurants do as I am sure there is a food loss there to.

[jainen]

"gross income"

When I have a non-business activity, I put "gross income" on Line 21. That's the same as Schedule C Line 7, sales minus cost of goods sold. Other expenses go on Schedule A.

[JG EA]

The sales is around $18000 and the food for resale runs around $20000 and this is before the sale tax,.permits,and other expenses are taken.They really are in it to make a profit and the work they do is not easy.

Then they don't have a business. If you have a negative gross income it can't be a business after a year or two.

Just wondering how the restaurants do as I am sure there is a food loss there to.

Restaurants make a profit. They watch carefully their profit percentage, especially regarding food for resale.

[jainen]

>>wondering how the restaurants do<<

They calculate the ratio between sales and wastage, and price the food accordingly. That way they make extra profit instead of a loss when they are wrong. If they can't turn a profit, they get a new gig. The food service industry is controlled by the big guys.

If your clients are doing it because they love crawfish or they love festivals, those aren't profit motives. Whatever their real motive may be, if it were profit they wouldn't try to sell crawfish at festivals.

[JG EA]

When I have a non-business activity, I put "gross income" on Line 21. That's the same as Schedule C Line 7, sales minus cost of goods sold. Other expenses go on Schedule A.

Thank you, thank you. This is good news to me. I couldn't find anything on this last year and called NATP - they are the ones to tell me not to use COG. Do you have a reference? In looking just now in pub 535 it did talk about order of deductions on A. The second category was clearly operating expenses. So, this a presumption of COG going directly on Line 21?

[Bees Knees]

COGS for a hobby does in fact go on line 21. See TTB, page 5-22, "Gross income for purposes of the hobby loss rules equals gross receipts minus the cost of goods sold deduction. Any consistent method for determining cost of goods sold is accepted as long as it follows generally accepted method of accounting. [Reg. Section 1.183-1(e)]"

There is also a good example that illustrates how to do it and take out inventory for personal use.

[Matt Sova]

Profit Motive

That is the a key ingredient in trying to figure out if this is a business or not. Do they advertise? Do they keep a separate bank account for the business? Do the keep a set of books? The 3/5 rule is bunk for the most part. A few years ago, I think in the quickfinder book, I read about someone who had losses for 8 or 10 years in a row (can't remember the specifics). Anyway, the IRS audited and deemed it a hobby and not a business activity. Taxpayer sued and won. The court basically said just because he is a poor businessman does not mean that he is not in this for a profit.

Your client's setup is much different than a restaurant. A restaurant is going to make the meals as they are ordered. Your client is making a great big batch of crawfish and then trying to get the sales. It does not mean they do not have a business. If an audit is their worry due to COGS being greater than Sales maybe they should calculate how much waste they have. Perhaps how many pounds they cooked and how many are left. Take that percentage multiplied by the cost and reclassify that to spoilage expense. Even if it stays as COGS he could very easily prove why the COGS is greater than the Sales.

Matt

[JON]

Not for Profit

The above is used phrase as well as hobby. The bigger question is-why would anyone keep such a business going??? If your only answer is I enjoy losing money-good luck. Cash business with no profits you better look like a business and this one does not sound right. Enjoying losing money will not help your arguement, but losing money in start up years would not get it thrown out. You need to be able to show why the loss happenned and when and why the profits will happen.