How To Prove to the IRS that Your Business is a Business

A Guide to Tax Audits for Business Start-Ups

In our tax dispute resolution practice, we have seen taxing authorities — like the IRS — send farmers, psychiatrists, day traders, clothing retailers, and electricians the dreaded NOTICE OF AUDIT, and thereafter, determine their “business” was not a business at all. Therefore, under IRC §62, their expenses are NOT deductible. This is a devastating determination and can cause severe back taxes and penalties on unsuspecting small business operators.   

A common purpose for tax authorities to audit small businesses is to attempt to differentiate “hobby” activities from “business” activities, and collect taxes from those who are using the guise of a business to take advantage of tax benefits.

Audits happen; they are scary, but they are manageable, so long as you have been managing your business with a few things in mind.

In assessing whether a business was run with a for-profit motive, rather than a not-for-profit motive, i.e. hobby, the Tax Commissioner looks at nine factors.

Below, I’ll explain what each factor is, and what you can do to demonstrate that you’ve been running your business for-profit. This is especially helpful if you're not exactly turning a profit: so long as you’ve been managing your business seriously, you have a fighting chance to show the auditors that you came prepared.

These factors come from  26 C.F.R. § 1.183-2(b)(1)-(9), Federal Regulations which provide guidelines for analyzing the business activity to make a determination between for-profit businesses and hobby businesses.

Any questions? Schedule a consultation with us and we can help you avoid an audit, or manage an audit you’re currently a part of.

1. Business Efforts.

Here, the Tax Authority is looking for your business skills, and how you’ve implemented them. Did you formally incorporate the business with the secretary of state? Do you have governing documents, like bylaws or operating agreements? Do you have a Board of Directors, do you keep minutes? How is your bookkeeping? Do you have an organized record of all business transactions, of profits and losses, expenses, inventory, payroll? If you had losses, how did you make changes to try to mitigate? Is there a record of that? Do you use your business credit card to get yourself a latte?

These questions are just the beginning. If you have any questions about what any of these things mean, schedule a consultation with us, no matter what stage of business you are in. These formalities do matter.

2. Expertise.

COVID saw the starkest increase of self-started businesses.[1] As inspiring as it is to drop your nine-to-five to be your own boss, a self-started business does not literally mean you have to start your business by yourself, especially where it concerns parts of the business where you are not exactly trained. You need advisors for those areas where you don’t have expertise: taxes, labor and employment, and accounting to say the least. That is not to say that you shouldn’t do your due diligence in preparing: in fact, the more research you do about starting your business, and making your business successful, the better off you are.

But it doesn’t end there: you actually need to implement the advice you are receiving! Sure, there may be exceptions, but be prepared to explain why you didn’t follow an expert’s advice if it comes to it.

3. Dedication.

This one is tough. Typically, you’d start a business because you’re passionate about the good or service your business provides. Sometimes, these things are more “fun” than others. What the tax authority looks for is whether you’re only working on your business to reap the benefits of what you offer, or whether you deal with the not-so-fun parts, too. Let’s imagine you started a business, selling homemade donuts online via a virtual market, after years of baking for fun at home while working an office job. A donut shop sounds pretty fun to me, and it probably sounds pretty fun to the ever-suspicious tax authority.

How do you go about managing your inventory – your raw ingredients, your donut-baking supplies? Are you the one reaching out to clients and filling orders? Did you hire someone else to do that if that’s not “your thing”? Did you quit your office job to make these donuts full-time?  If not, does someone else help you manage the donut shop while you earn income from that office job to assist with the expenses of the donut shop that hasn’t quite turned a profit just yet? Who is that person? What is their experience as it relates to donut shop management?

These are some more questions to consider. Being a business owner of a small business can be tough for an individual; the tax authority will levy the weight of your dedication.

4. Investment

What money are you putting into this with a reasonable expectation that you will get money out of it? How much of that money goes into assets? What are those assets? What is their likelihood of appreciating in value? Will those appreciated values exceed your investments? When?

Ask yourself these questions before the Tax Authority has to.

5. Your Past Business Adventures.

The phrase that comes to mind: “This isn’t my first rodeo.” Tell us about those other rodeos. We’ll keep with the online donut shop example: did you ever sell other baked goods commercially? Did you ever sell anything else commercially? Was it also an online shop? Was it a physical storefront? How were those businesses similar or different from the donut shop you’re running today? Tell me about the success of those businesses. Tell me about the ones that weren’t successful. We’ll draw some lines.

6. Historical Data.

We get it: the business is new. It takes time – and money – before a business can realize a profit, more often than not. But how much loss is too much loss? Keeping track of your financial trajectory, month to month, year to year, ultimately understanding (and explaining) where those losses came from, what decisions went into the expenses, and where improvements made to your business in some way lead to an improvement in income earned, is key.

7. Profits.

In this model, we’ll think of a chart and a graph.

First, think of a chart with two columns. Left column: profits. Right Column: losses. Which column is taller? This is a true balancing test that can shed light on whether you’re running a business for profit, particularly where you can’t see much profit.

Second, think of a line graph. Money over time. Do we see spikes in the profits earned over time? At what intervals? How often? How big are those spikes?

Mapping this out can, in the most literal sense, paint a picture as to how healthy your business is, and whether you can show that despite your investments, you’re still after a profit.

8. Your Financial Status.

Where is your money coming from? Are you relying on this business to keep you afloat? There are financial circumstances that are different for everyone, but the relationship between your finances and your business tells a story about why you are running the business.

9. Personal Motives.

While it is not enough that deriving joy from your business has a bearing on why you are running your business, it is certainly a question that the tax authorities ask. These are individualized: similar to the third factor, most people don’t start a business unless they are interested in the subject (though, sometimes, the subject is: make money.) The tax authorities will weigh this.

In conclusion, don’t wait until it’s too late to ensure your small business is operating in a healthy way. Let us help you avoid the “hobby” determination and ensure your business is meeting all 9 factors appropriately. We love assisting our small business customers ensure their operations and structure are efficient and effective.

Schedule a consultation with us today.

[1] The COVID-19 small business boom: startups surge during pandemic, by Maureen Soyars Hicks, September 2021. https://www.bls.gov/opub/mlr/2021/beyond-bls/the-covid-19-small-business-boom-startups-surge-during-pandemic.htm