Recent surveys show that over 70% of Americans consider themselves to be living paycheck to paycheck. It comes as little surprise, therefore, that Americans are becoming increasingly creative about increasing their income while minimizing the tax associated with that income.
Of course, the notion of owing less taxes on a higher income is a legal impossibility. The IRS defines gross income as “income from whatever source derived,” which is a rather wide net to cast. There are exceptions, though they are reserved for niche circumstances which rarely present an opportunity for a sustainable lifestyle. If a taxpayer realizes a higher income, they will be subject to higher income taxes unless there are substantial deductions to offset that income. This is where Section 162 of the Internal Revenue Code comes into play. Section 162 states generally that business owners who file a Schedule C are permitted to deduct all ordinary and necessary expenses paid during a taxable year. These deductions directly offset income, including income earned outside of the business.
Deductions under Section 162 must be both ordinary and necessary for the business being run in order to qualify. For example, a person who uses their own vehicle to drive for a ride-sharing app may generally deduct the costs of gasoline, as long as it is done in proportion to the vehicle’s business usage. Some taxpayers have attempted to exploit this code section to create a loophole wherein they can deduct expenses from a hobby. This is often done via artistic pursuits such as commissioned artwork or photography, but can be done with any hobby. A taxpayer who enjoys photography may attempt to capitalize expensive equipment or deduct the expenses for a vacation being taken under the premise of acquiring portfolio pieces. For a hobbyist, these expenses would likely have been incurred regardless of the existence of a business and are now being used to offset the taxpayer’s income. The IRS is familiar with these tactics and will scrutinize these returns more closely. The problem arises when a legitimate photographer reasonably needs to deduct similar expenses. Suddenly the bona fide business owner is being audited and risks having offsetting expenses erased from a tax return.
So how does a business owner distinguish himself from a bad-faith hobbyist? It’s all in the profit-motive. Under Section 183 of the Internal Revenue Code, an activity not engaged for profit is not eligible for the deductions under Section 162. Since the intent of the business owner is difficult to prove, the IRS will fall back on the presumption that an activity that produces income in excess of its expenses for 3 years out of the past 5 consecutive years is engaged in for profit. New business owners may have difficulty with this as profitability can take several years to materialize, but the presumption may be rebutted by the actions of the business owner. The IRS will consider several factors for the existence of a profit-motive in an unprofitable business, including but not limited to the time and effort spent by the taxpayer, the existence of leisurely motives in the activity, and whether the activity is being operated in a business-like manner. These factors provide a great deal of subjectivity and discretion on the part of the IRS.
A taxpayer who has gotten to the point of rebutting the IRS presumption of a lack of profit motive has likely already become the subject of an audit. This is a risk for any taxpayer who operates a business that may be considered leisurely in nature. The accurate preparation of tax returns and allocation of business-related expenses is key to reducing the risk of an audit, but there will always be some risk if the business is not profitable. Failure to provide an adequate response to the audit will result in the denial of the business expenses. The taxpayer will then be saddled with the taxes on all of the activity’s receipts without any offsetting expenses. For taxpayers who are attempting to make a living from their business, this could be devastating.
For this reason, it is important that taxpayers who are under examination for their Schedule C businesses contact a tax lawyer to advocate for them before the IRS. An experienced professional who understands the rules and tests of the Internal Revenue Code as well as the procedural aspects of an audit is pivotal in ensuring that a bona fide business owner is able to deduct qualified expenses from their gross income.
Thank you to the team at Crepeau Mourges for the above blog.