Becoming a small business owner brings with it a number of challenges. You are not only concerned with taking care of your client’s needs, getting paid and paying your vendors. You should also pay attention to remain compliant with federal and state laws and local guidelines. Small business owners, especially sole proprietors, are at increased audit risk. The federal government believes that the self-employed are under-reporting their income and under-reporting their expenses. According to the website Tax Help Online, “You may be surprised to learn that 20% of all small business audits involve banning withholding because the IRS reclassifies small business as a hobby under the so-called ‘lost hobby’ rule.” The Internal Revenue Code Section 183 (Activities Not Performed For Profit) limits the deductions that can be claimed when an activity is not performed for a profit. IRC 183 is sometimes referred to as the “lost hobby rule”. As a small business owner, it’s your responsibility to make sure your business is seen as a legitimate business in the eyes of the IRS and not a hobby.
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’re running a real business and not just a hobby.
1) Write a business plan. There are many local small business support centers that can help you write your plans. For example, the Small Business Administration has local and online resources to help you.
2) Determine your legal structure (LLC, Partnership, C-Corporation, S-Corporation, Sole-Proprietor).
3) Obtain an Employee Identification Number (EIN) from the IRS.
4) Open separate bank accounts for all your business transactions (deposits and expenses). You need to keep your personal and business transactions separate.
5) Assign a separate line of credit or credit card to use with your business. Enter personal expenses on personal cards and enter business expenses on business cards.
6) Keep your business documents organized. The National Federation of Independent Business recommends retaining business records and receipts for at least seven years.
7) Completing tax returns on time. This will include all necessary schedules and signatures. Depending on the type of organization you have, you or your CPA will fill out forms such as 1020, 1065, 1040 Schedule C, 1096, 1099, 940 along with calculating your self-employment tax. I highly recommend seeking out a local Certified Public Accountant (CPA) who is familiar with your industry to help you determine which forms you should file and ensure they are submitted on time and to the right government office.
8) Hire a support team: An attorney can help you with your legal structure and a Certified Public Accountant can help you keep your finances in order as well as keep you compliant with local, state and federal governments.
9) Create industry standard business documents and forms to include: logos, letterhead, business cards and websites.
10) Advertise in your local media along with appropriate trade magazines.
According to the IRS document, FS-2008-23, below are some of the questions the IRS may ask when determining whether your business engages in for-profit activities. You should be prepared to answer these questions and provide documentation.
1) How many hours a week do you work in this business?
2) Do you depend on the income from this activity to pay your bills?
3) Do you have the knowledge needed to operate as a successful business?
4) Have you profited from similar activities in the past?
5) Is the activity profitable in a number of years?
6) Do you expect the activity to be profitable in the future?
7) Is there an element of personal fun or recreation?
8) Has your business made a profit in the last 3 out of 5 years?
According to IRC 183, “If your business activities are not conducted for profit, the allowable deduction must not exceed the gross receipts for that activity.” The result is that your business deductions will now be itemized and limited to your hobby income.
For more information and assistance in helping your company maintain its position as a legitimate business, please contact your local CPA. Each state has its own independent licensing board. If you are in North Carolina, you can contact the NC CPA Board website and click the “Search Licensee” button to find a CPA near you. All licensed and active CPAs in North Carolina will be found on this website.
