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Self Employment, Financial Freedom or IRS “Invitation” ?
July 3, 2019   |   Form 1040, IRS, Legislation, Tax Planning-Business, Tax Resources, Taxes

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Are you a self-employed business owner?   It’s great to set your own hours and choose your “job”.  However, if a business owner isn’t careful, the ticket to financial freedom–the business–can be an “invitation” for an IRS inquiry .  . .

The IRS defines a business as a FOR PROFIT activity. Translation: Just because you call it a business, does not mean the IRS accepts it as one.  Generally a TRUE business:

  1. Keeps books and records
  2. May have a business plan
  3. Shows a profit for some years (traditionally at least three of five years or two of seven years if horse breeding, raising or racing).
  4. Devotes significant time to the activity
  5. May have industry expertise or consult with other industry professionals.

If  your activity is a “TRUE” business, then most business expenses and losses are deductible.

If the business shows a pattern of losses (especially large losses), the IRS may accept your “invitation” to investigate the business.  If the IRS finds:

  1. Pattern of losses over a series of years
  2.  Poor or non existent books and records
  3.  Poor management:  no attempts to reduce expenses, make activity more profitable.
  4. Significant other sources of income
  5. Little or no expertise in the activity
  6. Significant pleasure in the activity (I’d do the work for free)

Then the IRS may classify the activity as a HOBBY. It’s common sense, an activity “swimming” losses won’t be in business very long. Result: Activity income becomes fully taxable. Expenses are limited and losses are NOT allowed.

How does this affect the tax return?  The IRS removes activity losses claimed resulting in a tax bill plus penalty and interest. [OUCH!]

So if self employment is your path to financial independence, be responsible. Keep good books and records and manage the business well to avoid giving the IRS an “invitation” for a business or “Hobby” inquiry.

For more information, see IRS Publications 535 529 and 536& IRS Tax Code 26 USC 183 (Not for Profit) and 26 USC 162 (Business Expenses)
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