A common source of audits that I’ve seen in the past is where taxpayers claim Schedule C business expenses for side jobs selling a myriad of different things including cosmetics, nutritional supplements and other industries.
The problem arises when the IRS sees that the taxpayer is not making a profit on this business for an extended period and showing losses on the business. This typically arises from a Schedule C that has very little income, but quite a large amount of expenses.
Let’s look at an example of what I’m talking about.
Taxpayer A has a business selling cosmetics that she started in 2013. Her gross income, expenses and net profit or loss are:
2013- Taxpayer A makes $2,000.00 in her first year of business and has $2,000.00 of expenses. Her net profit/loss is zero.
2014: Taxpayer A makes $4,000.00 and $4,500.00 of expenses. Her net loss is $500.00
2015: Taxpayer A has a bad year, but a lot of expenses since she thought this year was going to be like last year’s income. She makes $1,000.00 and has $5,000.00 of expenses. Her net loss is $4,000.00
2016: Taxpayer A makes $2,500.00 and has $4,000.00 of expenses. Her net loss is $1,500.00.
2017: Taxpayer A finally makes a decent profit. She makes $4,000.00 and her expenses are $3,000.00. She has a net profit of $1,000.00.
In the above scenario, under IRC Section 183(a), the IRS should hold that Taxpayer A was engaged in a business not for profit, would consider it a hobby and disallow all of the expenses even though these expenses would be otherwise deductible and legitimate under the Code.
BUT: Let’s look at Subsection(b): Here, the IRS still allows all of the other deductions that would normally be allowed such as child tax credits and mortgage interest AND expenses up to the amount of income actually received.
So, it’s not a total loss when it comes to an audit. Some of the expenses would be allowed, but those above and beyond the income received would be disallowed. In the case of our Taxpayer A, between 2013 and 2017, a grand total of $6,000.00 of expenses would be disallowed under the rule.
I will say that in my experience, revenue agents and tax compliance officers aren’t always ready to apply subsection (b) in favor of the taxpayer, but appeals will.
The Section 183 Presumption
Under subsection(d), if the taxpayer shows that a profit has been made in three out of five years, then the activity is presumed to be for profit and section 183 does not apply.
In our scenario, Taxpayer A cannot show that she made a profit in three out of five years. We could argue that she didn’t post a loss for two out of the five years since 2013 was a wash. However, because she’s missing that one extra year of profitability, section 183 would apply.
So, where does this all leave the common taxpayer who is operating a business on the side?
Be careful when operating your business and understand the rules and what happens if you post consecutive losses on your business. Know that you can’t deduct all of your expenses even if they were incurred if you do post consecutive losses three years in a row over a five year period.
AN IMPORTANT CAVEAT: This rule only applies to individual taxpayers and Subchapter S Corps. It does not apply to C Corps or any other taxable entity.
THIS IS A PRETTY TRICKY RULE SO IF YOU HAVE ANY QUESTIONS ABOUT IT, FEEL FREE TO CALL ME, LEAVE A COMMENT OR SEND ME AN EMAIL!
https://www.law.cornell.edu/uscode/text/26/183