schedule c loss

[POCAHONTAS]

client made a loss for 2003,2004,2005 then moved to a different state started up again made a small profit and then made a loss again for 2007. question is how will the hobby loss rules affect this client and is he a candidate for an audit? (I am just wondering if I should do his taxes???)
thanks

[erchess]

Based on what I have been taught

the real question here is whether this activity qualifies as a hobby or as a business. There is an excellent discussion of that TTB 5-19 and 5-20. I think if you will read the material, give him a copy to read, and have a conversation with him, you will know what to do. None of us needs the sort of client who wants to play fast and loose with the rules. Our job is to help those who hire us pay all of the tax that they owe under the relevant laws and no more than this amount. I myself have in the past played fast and loose with the hobby vs business issue because when I started out in the business that was what my employer wished for me to do. Since I went out on my own I try to ride herd on that habit.

[POCAHONTAS]

thanks erchess I did read the two pages on ttb and number 7 on page 5-20 is similar to his situation but this guy says he had to move to Arizona in 2006, to see if he can make a profit there and he did make a small amount of profit, but then he business did not do well and he made a loss in 2007. he does own machinery and equipment, and also has experience in the business, and says that he had to start all over again in Arizona hoping that he will make a profit. He insists that he is still in business and should be allowed the loss, so my question is if he was audited will his argument be valid, I am at a loss he sounds genuine but then I am new in the business and don't want to risk anything. But then again this case is quite interesting.

thank you

[Lion]

Starting over

I lost one at audit that I thought we had a good case for business, not hobby. Wrote up comments on the various points. He'd lost a lease and had to move, finding new clients, then lost again and moved farther but to an area when there were more potential clients. Also, had a couple of accidents to property. So, he started over three separate times, but auditor wanted a profit in the third year. It's going to depend on the auditor and if you can present it in a manner she will listen to (ours had made up her mind before I walked in the door and told me so!). But, you can't prepare his taxes as if you'll get a stubborn auditor; you have to prepare them for the reality of the situation. Read the Nine Points with your client and decide whether it's a business or a hobby and file accordingly.

[abby]

hobby

One thing someone told me once - you are not required to be successful in business. You have to have the motive to be successful, but you don't get penalized because you're a bad businessperson. What is his business exactly?

The hobby loss rules, as I understand them, are mainly to ferret out folks who are doing something they would do anyway, for their own pleasure. I see it in my work because I deal with folks in the performing arts. One also sees it with other artistic pursuits and then there's horse breeding and dog breeding and such. It's when it's hard to determine whether the desire to pursue an activity is mainly for personal reasons. It's certainly great to have pleasure and fulfillment no matter what your pursuit - but would you do it anyway if you weren't getting paid? This determination is sometimes more difficult to make than it may seem.

The hobby loss rules, are a safe harbor - not a requirement - so that if you can show the profit in 3 out of 5 years, your pursuit shouldn't be questioned as to profit motive. I say shouldn't, because I'm sure there are audits where the auditor would try to apply them when they aren't really pertinent.

If this is not a question, and this is clearly a business, then the losses are not automatically restricted by the 3 out 5 rule - losses can be claimed as they occur. I'm not saying it won't be examined, and it's always wise to counsel our clients to run their businesses professionally - keeping good records, etc, but it is possible to have years of losses and still have a profit motive.

[Bees Knees]

In a nutshell…

If you are going to do things the way an IRS auditor sees it, you must make a profit in 3 out of 5 years.

If you are going to do things the way the courts see it, you must have a profit motive, conduct the business like a business, and not have any fun doing it. In this case, you can lose money 20 years in a row and still be a business.

It all depends on whether you are willing to take your case to court, or whether you want to fold the minute the auditor voices his/her opinion.

[totb2007]

Well, if you suspect such a situation (given the background you have presented it seems likely), then it's best to plan ahead so that if your client to be does get that audit notice, you can then whip out your work on those nine points you addressed with client and present it to the auditor. Chances are, if you were convinced that the client's arguments are good or reasonable and the documents to support them plentiful, then the auditor will drop it. The idea is the paint the picture you want the auditor to see. Make it easy for them to drop it. Of course, you could get an auditor like Lion, but preparing taxes as if you will is not doing your client any favors.

If your client is vague on details and their evidence poor, that auditor is going to be a like a shark in the ocean sensing blood in the water. And what due diligence can you say that you have done as the preparer knowing what you know?

[Black Bart]

Hobby loss? Business?

client made a loss for 2003,2004,2005 then moved to a different state started up again made a small profit and then made a loss again for 2007. question is how will the hobby loss rules affect this client and is he a candidate for an audit? (I am just wondering if I should do his taxes???)
thanks

I've done a few and I'm with the rest of the crew -- do it if you think it's for real and don't if not. One of mine was a "cattle rancher" and I eventually had to run him off (had good documents, but over a six year run I eventually came to believe he was fakin' it), another I'm doing now (fourth year) and am 97% sure it's a bona fide professional service, a third -- um...not so sure...maybe yes...maybe...um...I dunno..he's gonna have to shape up or ship out by season #3 (and I told him so).

But before you get into the risk and ethics and so forth, decide if you want this client from now on. After saving several thousand dollars with his snout in that trough, he isn't going anywhere -- you'll have to beat him off with a wet toe sack or pull a shotgun to make him go 'way.

About the risk -- I've heard dire warning about "hobby losses" for years, but have never really seen anything materialize about it. This following article (paraphrased) was in a recent monthly taxletter and, while they didn't quote a source, it sounds about right to me.

Treasury Dep't. inspectors say thousands of taxpayers annually are claiming hobby losses as fully deductible "business losses" and IRS has been ineffective at stopping them. The inspectors identified 1.5 million such returns and 332,000 of them were filed by individuals earning over $100K from other sources while claiming Schedule C losses for four consecutive years (2002-2005). Of that 332,000, 204 reported either no gross sales at all, or expenses at least two times gross receipts -- indicating that after four years these "businesses" were not close to making a profit. To address the problem, IRS sent letters reminding the taxpayers of the rules against deducting hobby losses, but "the taxpayer response was low." Additionally, IRS used "correspondence audits" -- mail notices not involving actual records examination -- to disallow loss deductions of a sampling of the returns. A later follow-up study found over 1/2 resumed deducting the same losses in later years. IRS now says it will increase educational efforts to better inform taxpayers about the hobby loss rules, but has no plans to increase audits of hobby loss returns, due to its limited resources.

Of course, while we shouldn't celebrate the crooks' "getting away with it," it would be nice to think that maybe IRS is not (knock on wood) breathing hotly down our necks either.

[oceanlovin'ea]

What I look for

When I am considering if a person is really in business to make a living or a profit or just a hobby is how they run their business. If this is the only endeavor of the man (maybe his wife works a day job) and he has a business license, a business plan, business cards, makes contacts to promote his business on a daily or weekly basis, I would think he is in business even if he has losses.
If he spends a day or 2 a month, then it could be questionable if he is not doing something.
Business checking accounts also would be a sign a person was conducting a business. Hobby people tend to pay out of own money.

I have a client who makes jewelry. She has had losses for about 5 years. But she had to find a market for her jewelry. She tried one place one year and didn't have good success. So the next year she tried something else. She went to art shows and craft fairs and advertised in journals. This year she had a small profit.
I think you have to take each case individually. You can't make a blanket rule that will apply to all people. So just talk to him, look at what he is doing to make his business work. (Some people have the worst things happen to them). You will make the right decision.

Linda F

[POCAHONTAS]

this client is a machinist and works on racing cars and he moved to a town where there is racing so he could get more business working on those cars. He did buy a large empty building and moved all his equipment there in 2006. He did do a substantial amount of repair to this building in 2006 to turn it into a garage. Yes his wife does have a full time job.

I hope this sheds some light on the matter. At first I was leaning towards not taking on this client but now from reading all the responses this has become quite interesting so now I am back to square one, do I take this guy on as a challenge and if he gets audited, gain some experience from it, but then the question is, "will I be just creating trouble for myself"??

[erchess]

Trouble for you

Ok you read the relevant part of the Tax Book. You have I think talked to him. If need be, talk to him more. Make careful notes about what he says about how his business stands up to the tests in TTB. Then decide for yourself how persuasive his story is. You will not get in trouble if he has a story that is not illogical or inconsistent with itself or with facts you can directly observe and that reasonably supports the notion that he meets the standard.

By the way, the hobby loss rules to not apply to C or S Corporations. Corporations are deemed to be businesses,

[Bees Knees]

By the way, the hobby loss rules to not apply to C or S Corporations. Corporations are deemed to be businesses,

The hobby loss rules do not apply to C corporation. They do, however, apply to S corporations.

IRC §183(a), "In the case of an activity engaged in by an individual or an S corporation, if such activity is not engaged in for profit...."

[erchess]

TY for the correction Bees

You have saved me from possibly misleading a client in the future.

[POCAHONTAS]

thank you

thank you everyone for all your input

[ChEAr$]

Ranciato

Pocahontas, get a hold of a copy of the Ranciato case which deals with lack of success
turning a profit. You might do a Google search for it .