What happens when your claims regarding small or home-based business expenses on IRS Form 1040 Schedule C, Profit or Loss from Business (Sole Proprietorship) are disallowed? The Internal Revenue Service (IRS) has guidelines that determine whether or not a business activity is carried on for profit. Rulings fundamentally rest on a determination whether or not business activity has been profitable in three of the last five (or the special case; two out of the last seven) tax years (including the current year) reported. If your business fails the "three-years-of-profit" test, the IRS applies Internal Revenue Code (IRC) Section 183 (Activities Not Engaged in for Profit), also known as the " hobby loss rule ". When your activities are viewed as a hobby rather than a for-profit business, tax claims reported on the 1040 Schedule C are disallowed, but not forgotten! All income previously reported on Schedule C is now reported as a write-in entry "hobby income" on Form 1040 Line 21, Other Income. Unlike business losses that are subtracted from any reported business income, hobby "losses" can only be reported as an Itemized Deduction on Line 23, IRS Form 1040 Schedule A under Certain Miscellaneous Deductions. This category of deductions is subject to a 2% threshold based on the adjusted gross income (AGI). If a taxpayer does not itemize their deductions, these previously legitimate losses will be lost leaving all the income subject to income tax rates.
The fact that the expenses, associated with "hobby" -related activities, are now reported only if the taxpayer chooses to itemize deductions and then, subject to the 2% -of-AGI limitation, is only half the story! Like gambling income, all hobby expenses are limited by the total amount of hobby income reported on Form 1040 Line 21. Furthermore, expenses can only be deducted in a specific order from the reported income. The first category to be deducted from the income relates to home mortgage interest and real estate taxes especially if your hobby requires physical space. After these expenses are applied to the reported income, deductions for advertising, utilities, insurance premiums, and operation-related costs can be deducted. Finally, if any amount of hobby income remains, depreciation and amortization of property can be applied. When only part of the depreciation expense can be applied to the remaining reported income, it is allocated across all depreciable assets involved with the hobby.
Do you have a record of profitable past performance and believe you are just in a business cycle slump? If you receive a notice from the IRS that raises the question of profit motive because of the "three-years-of-profit" guideline, you have 60 days to file IRS Form 5213, Election to Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit. Best practices suggest that you should file this request only in response to correspondence from the IRS rather than as a proactive measure. Seek professional advice especially regarding the timing of any tax-related filings with the IRS. Pay for professional advice especially when filing income taxes; don't be penny-wise and pound-foolish!