Being a small business owner comes with a number of challenges. You are not just about looking after your customers’ needs, getting paid, and paying your suppliers. You must also be careful to comply with federal and state laws and local guidelines. Small business owners, especially sole proprietorships, are exposed to an increased risk of audits. The Federal Government assumes that the self-employed state their income massively too little and their expenses too much. According to Tax Help Online, “You might be shocked to learn that 20% of all small business audits are denied deductions because the IRS classifies the small business as a hobby under what is known as the ‘Hobby Loss Rule’.” Section 183 of the Internal Revenue Code (Non-For-Profit Activities) limits the deductions that can be made when an activity is non-profit-making. IRC 183 is sometimes referred to as the “Hobby Loss Rule”. As a small business owner, it is your responsibility to ensure that your business is viewed as a legitimate business, not a hobby, in the eyes of the IRS.
Below I’ve listed some smart business practices that will not only help you define and grow your business, but will also help you document that you are running a real business, not just a hobby.
1) Write a business plan. There are many local small business support centers that can help you put your plan in writing. For example, the Small Business Administration provides both local and online resources to assist you.
2) Determine your legal form (LLC, partnership, C-Corporation, S-Corporation, sole proprietorship).
3) Obtain an Employee Identification Number (EIN) from the IRS.
4) Open a separate bank account for all your business transactions (deposits and expenses). You need to keep your personal and business transactions separate.
5) Set up a separate credit or credit card for your company. Put personal expenses on a personal card and business expenses on a business card.
6) Keep your business documents organized. The National Federation of Independent Business recommends that business records and receipts be retained for at least seven years.
7) Submit completed tax returns on time. This includes all the necessary schedules and signatures. Depending on the type of organization you have, you or your CPA will fill out forms like 1020, 1065, 1040 Schedule C, 1096, 1099, 940 and calculate your self-employment tax. I highly recommend finding a local Certified Public Accountant (CPA) familiar with your industry to determine which forms to submit and to ensure they are submitted on time and to the correct government agency.
8) Hire a support team: an attorney can help you with your legal structure, and an auditor can help you keep your finances in order and comply with local, state, and federal government.
9) Create industry standard business documents and forms with: logo, letterhead, business cards and website.
10) Advertise in your local media along with relevant trade magazines.
Pursuant to IRS Document FS-2008-23, the following are some of the questions the IRS may ask when determining whether your business is for-profit. You need to be prepared to answer these questions and provide documentation.
1) How many hours a week do you work in the company?
2) Do you depend on income from this activity to pay your bills?
3) Do you have the necessary knowledge to operate as a successful company?
4) Have you made profits from similar activities in the past?
5) Will the activity be profitable in a few years?
6) Do you expect the activity to be profitable in the future?
7) Are there elements of personal pleasure or recreation?
8) Has your company made a profit in 3 of the last 5 years?
According to IRC 183: “If your business is not for profit, the allowable deductions must not exceed the gross income for the activity.” The result is that your business prints now become individual prints and are limited to your hobby income.
For more information and assistance in helping your business maintain its position as a legitimate business, please contact a local CPA. Each state has its own independent licensing agency. If you are a North Carolina resident, you can contact the NC CPA Board website and click the “Find Licensee” button to find a CPA near you. All licensed and active CPAs in North Carolina can be found on this website.