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Schedule C Business - Losses for last 5 year + Current Year

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Level 3

I have a client who has had a business that they have operated for the last 10 years, but have never recorded a significant profit for the business.  This year, another significant loss, and the client raised the question if they needed to provide the tax schedules for the business they operate on their schedule C.  This is a sole proprietorship that they intend on turning into a profitable business, but do not want to raise the red flag to the IRS for an audit.  

There feeling is to withhold reporting anything for the business, but I'm concerned the IRS will then see this as a terminated business making it more complicated in the future.

Please let me know your thoughts.  Thank you in advance!

Tom

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Highlighted
Level 11

If your question is, "Should I leave $5,000 income off the return because my client told me to?" the answer is No.

Have you gone through the checklist? We can’t give you an answer if you don’t tell us which one bothers you. You do know there is a checklist, right?

Section 1.183-2(b),Income Tax Regs., lists the nine factors to consider:
• manner in which the taxpayers carry on the activity;
• expertise of the taxpayers or that of their advisers;
• time and effort expended on the activity;
• expectation that assets used in the activity may appreciate in value;
• success of the taxpayers in carrying on other similar or dissimilar activities;
• history of income or losses with respect to the activity;
• amount of occasional profits, if any, from the activity;
• financial status of the taxpayers; and
• any elements of personal pleasure or recreation.

You can read dozens of Tax Court cases where this checklist is methodically applied to the facts. Many of the cases involve horse farms, because those are more likely to involve $50K, not $5K in losses. But the same rules apply to all (if you are using the “taxpayer always wins” rule on burden of proof, the number of years before a profit is shown is higher for horses).

My favorite opinions are those by Judge Holmes, who often includes some wordplay. For example, see the 2015 case of Metz at

https://ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=901  

It’s 66 pages of easy reading, but you don’t have to get past Page 5, which explains:

Horse-farm cases come in herds and not in single stallions, and are among the most frequently litigated under section 183. Each case turns on its facts, see, e.g., Pederson v. Commissioner, T.C. Memo. 2013-54, at *59 (comparing a small sample of five horse-breeding cases with different outcomes), which can vary widely. They range from the wealthy businessman who runs a real business but keeps a gentleman’s farm as a weekend retreat whose expenses he tries to subsidize through deductions to sophisticated, well-run operations that just haven’t been able to consistently make a profit. See Helmick v. Commissioner, T.C. Memo. 2009-220, 2009 WL 3012725, at *7

These cases blaze a helpful trail to the facts that we should look at in any individual case, but they are not precedents from which one can derive ever more precise statements of law. We must not lose sight of the Ninth Circuit’s lodestar:

“The proper focus of the test to be applied * * * is the taxpayer’s subjective intent.” Wolf, 4 F.3d at 713 . . .

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12 Replies 12
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Level 15

Is there EIC involved?

Former Chump... umm.... AllStar.
If a post answers your question, click on *Accept as solution* for future searches
Highlighted
Level 3

Yes, in 2018 EIC was a factor.  Doesn't appear that EIC will be in play for 2019.

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I suspect receipts from the business would still meet the definition of "gross income" under IRC Section 61 "...all income from whatever source derived...."  So you might want to focus on the issue of how to report it (i.e., is it a trade or business, or just a hobby), rather than on whether or not to report it.  Just a thought.

And for the record, I'm a dog....so I don't qualify for Level 1, 2, 3 or otherwise.  Never have.

Highlighted
Level 3

Great point.  They had around $5K in gross receipts, but huge expenses to offset.  Any thoughts on justification for hobby/business?  The State of Illinois rejected their refund for 2018 because of the years of losses on the business.  The comment I received from the agent I talked with said this came right out of the IRS publication and "they should have refused the federal refund by their rules".

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Level 7
 
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Level 15
Profit is not the only determining factor, just a measuring stick. What type of business? Is it the only activity run by the individual? Do they have a day job? ....
https://www.irs.gov/pub/irs-utl/irc183activitiesnotengagedinforprofit.pdf

ex-AllStar
Highlighted
Level 3

Yes, the spouse has a day job that they use to finance the spouses business she runs.

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Level 10

Who's funding the huge expenses? 

** I'm still a champion... of the world! Even without The Lounge.
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Level 3

The spouses day job.

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Level 12

IL has sales taxes which means filing and reporting; I use the word "discoverable" as in, are they in business or not? Having profit or loss doesn't define if that specific year "we are in business" vs "we are not in business."

What the heck is "Significant Profit" and how does that apply to being in business?

*******************************
"Level Up" is a gaming function, not a real life function.
Highlighted
Level 11

If your question is, "Should I leave $5,000 income off the return because my client told me to?" the answer is No.

Have you gone through the checklist? We can’t give you an answer if you don’t tell us which one bothers you. You do know there is a checklist, right?

Section 1.183-2(b),Income Tax Regs., lists the nine factors to consider:
• manner in which the taxpayers carry on the activity;
• expertise of the taxpayers or that of their advisers;
• time and effort expended on the activity;
• expectation that assets used in the activity may appreciate in value;
• success of the taxpayers in carrying on other similar or dissimilar activities;
• history of income or losses with respect to the activity;
• amount of occasional profits, if any, from the activity;
• financial status of the taxpayers; and
• any elements of personal pleasure or recreation.

You can read dozens of Tax Court cases where this checklist is methodically applied to the facts. Many of the cases involve horse farms, because those are more likely to involve $50K, not $5K in losses. But the same rules apply to all (if you are using the “taxpayer always wins” rule on burden of proof, the number of years before a profit is shown is higher for horses).

My favorite opinions are those by Judge Holmes, who often includes some wordplay. For example, see the 2015 case of Metz at

https://ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=901  

It’s 66 pages of easy reading, but you don’t have to get past Page 5, which explains:

Horse-farm cases come in herds and not in single stallions, and are among the most frequently litigated under section 183. Each case turns on its facts, see, e.g., Pederson v. Commissioner, T.C. Memo. 2013-54, at *59 (comparing a small sample of five horse-breeding cases with different outcomes), which can vary widely. They range from the wealthy businessman who runs a real business but keeps a gentleman’s farm as a weekend retreat whose expenses he tries to subsidize through deductions to sophisticated, well-run operations that just haven’t been able to consistently make a profit. See Helmick v. Commissioner, T.C. Memo. 2009-220, 2009 WL 3012725, at *7

These cases blaze a helpful trail to the facts that we should look at in any individual case, but they are not precedents from which one can derive ever more precise statements of law. We must not lose sight of the Ninth Circuit’s lodestar:

“The proper focus of the test to be applied * * * is the taxpayer’s subjective intent.” Wolf, 4 F.3d at 713 . . .

View solution in original post

Highlighted
Level 12

"IRC § 183(d) is a safe harbor for the taxpayer. It allows a presumption that the taxpayer is engaged in for profit if in 3 of 5 consecutive years (2 of 7 in the case of breeding, training, showing or racing of horses), the activity is profitable."

I had this scenario described to me as follows: You can have losses more often than 3 in 5. That doesn't mean you are not running a business. That means you are bad at business and need to stop trying.

I didn't realize the TCJA can have affected a taxpayer's understanding of what they write off as hobby vs business. To be fair to your client, it's time to give them updated guidance:

https://www.thetaxadviser.com/issues/2018/nov/avoiding-hobby-loss-trap-after-tcja.html

They should already know better than what they are trying to pull off.

*******************************
"Level Up" is a gaming function, not a real life function.