Starting a new business has many challenges. One of the more significant challenges is generating sufficient cash flows to sustain the business. Working with an experienced tax professional for tax preparation and tax planning when creating a new business entity, one can minimize or avoid these challenges.
One of the major sources of cash flows is revenues. If expenses of the business exceed revenues, then the business owner has negative cash flows, a potential liquidity problem, and perhaps an IRS problem. Why an IRS problem? The IRS has rules that limit the deductibility of expenses and losses from a hobby or activity not engaged in for profit. If the IRS determines that an activity is not profit-driven, deductions from the activity are limited to the amount of income the activity generates. Losses from such activities cannot be used to offset other income, such as salary or investments.
The business owner must be prepared to show that an activity that generates deductions is a business intended for profit. It is not necessary that the activity actually earns a profit, so long as a profit is one of the motives for participating in the activity.
The IRS assumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year. (There are special rules regarding businesses related to breeding, showing, training or racing horses). Otherwise, the IRS applies non-exclusive tests and factors to the surrounding facts to judge whether activities are more like a business with a profit motive, or are for personal satisfaction.
To make sure you are properly claiming all of the deductions available to you, and to strengthen your position in the event of an IRS audit, it is important to consider all the facts and circumstances surrounding activities the IRS is likely to challenge.
Note: Because each individual’s tax situation is different, if you want to learn more about documenting the for-profit characteristics of your activity, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation.
We wish to thank CCH Incorporated for its contributions to this post.
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