What Counts as a Deductible Business Loss?

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by Mary Mullaney

Sometimes a business loses money; it’s a fact of life. Of course, most business owners think that incurred losses offset earned revenue, thereby lowering taxable income and saving money in the long run. Unfortunately, that line of thinking is not always correct. This blog explains why.

As a result of a recent report from the Treasury Inspector General for Tax Administration (TIGTA), additional documentation may be required in the near future to convince the IRS of the validity of business endeavors. In order to deduct a business loss, the IRS says you must have a profit motive. Profit motive is the concept that firms operate in a way that maximizes their profits; without profit motive, the business is deemed a hobby and losses are not deductible against Adjusted Gross Income (AGI).

Apparently, a substantial number of taxpayers are actually engaged in hobbies instead of business activities. In fact, the TIGTA estimates that in 2013, taxes were reduced by as much as $70.9 million as a result of hobby losses deducted in error. Not surprisingly, the TIGTA recommended increased scrutiny by the IRS to identify and follow up on these types of violations—and the IRS is listening.

So, how can you prepare for that dreaded letter from the US Treasury requesting proof that your business losses were not actually hobby losses? The best way is to ensure you have profits in at least three of the last five years of your activity, which, according to IRS rules, validates the presence of a legitimate business.

Barring that, there are some other things that will demonstrate you are not spending all your free time engaging in your hobby in order to deduct the related expenses.

  • Evidence of a profit motive may be exhibited by your financial situation. Not having substantial income from other services would be a good start to proving the presence of a business activity.  Occasional substantial profit is also generally indicative of a profit motive. However, don’t despair if you have sustained losses following a history of income.  If you can provide evidence that your downturn is the result of customary business risks or reversals, it is not necessarily a foregone conclusion that you actually have hobby losses.  You may be able to continue loss recognition until your business turns around.
  • Demonstrate a comprehensive commitment to your business and show that you conduct it in a professional manner with an eye toward profitability. Maintain complete and accurate books and records.  Ensure you have the expertise for your enterprise by obtaining enhanced training or study, or by consulting with a professional in the field.  Provide evidence that you spend a significant amount of your time and effort involved with your business. Successful endeavors in other similar activities may also be a key indicator.  Finally, if at all possible, you should take action to improve profitability in the case of a sustained downturn.

If, after all of this, you determine that there is no profit motive and your loss is, in fact, a hobby loss, you may still deduct expenses up to the amount of your hobby revenue.  However, unless otherwise deductible elsewhere on Schedule A, they are considered miscellaneous itemized deductions subject to the 2% AGI limitation.  Since your losses are not included in your AGI, your itemized deductions are now subject to a higher AGI limitation, which affects both medical expenses and miscellaneous itemized deductions.

As a result of this expanded effort by the IRS to identify hobby losses, you should expect your tax preparer to quiz you a bit more on your business motivation if you’ve incurred repetitive losses in your business.  If you cannot provide reasonable assurance of your profit motive, you should probably start planning for that higher tax bill!

Reach out to your Moneta Group advisory team or Tax Strategies if you have questions!