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Self Employment, Financial Freedom or IRS “Invitation” ?
Are you a self-employed business owner? It’s great to set your own hours and choose your “job”. However, if a business owner isn’t careful, the ticket to financial freedom–the business–can be an “invitation” for an IRS inquiry . . .
The IRS defines a business as a FOR PROFIT activity. Translation: Just because you call it a business, does not mean the IRS accepts it as one. Generally a TRUE business:
- Keeps books and records
- May have a business plan
- Shows a profit for some years (traditionally at least three of five years or two of seven years if horse breeding, raising or racing).
- Devotes significant time to the activity
- May have industry expertise or consult with other industry professionals.
If your activity is a “TRUE” business, then most business expenses and losses are deductible.
If the business shows a pattern of losses (especially large losses), the IRS may accept your “invitation” to investigate the business. If the IRS finds:
- Pattern of losses over a series of years
- Poor or non existent books and records
- Poor management: no attempts to reduce expenses, make activity more profitable.
- Significant other sources of income
- Little or no expertise in the activity
- Significant pleasure in the activity (I’d do the work for free)
Then the IRS may classify the activity as a HOBBY. It’s common sense, an activity “swimming” losses won’t be in business very long. Result: Activity income becomes fully taxable. Expenses are limited and losses are NOT allowed.
How does this affect the tax return? The IRS removes activity losses claimed resulting in a tax bill plus penalty and interest. [OUCH!]
So if self employment is your path to financial independence, be responsible. Keep good books and records and manage the business well to avoid giving the IRS an “invitation” for a business or “Hobby” inquiry.
For more information, see IRS Publications 535 529 and 536& IRS Tax Code 26 USC 183 (Not for Profit) and 26 USC 162 (Business Expenses)
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