Throughout my career, I have been asked by many clients, especially when filing a tax return with a significant tax balance due, “Should I start a side business for the additional tax deductions and/or losses?” or something very similar to that effect. The goal of the client is to reduce or avoid completely a large tax burden in the future.
While the answer could be a very straight forward ‘yes’, there are variety of questions and risks to consider.
If you start a new business, it is very common to incur losses in the first several years. If you are taking all necessary measures to be actively engaged in a “for-profit” business, then you are entitled to deduct the business losses against other ordinary income (Best of example of ‘ordinary income’ is wages) on your tax return.
Some of, but not all, of the necessary measures to be actively engaged in a “for-profit” business include the following:
The activity is regularly profitable:
The IRS (Internal Revenue Service) looks at all facts and circumstances regarding a “for-profit” business versus a Hobby. A regularly profitable business puts forth a very strong argument in your favor if the IRS disallows losses from any other years. A general rule is three out of five years of profitability.
Obviously, if the activity produces a profit for the year, then you will owe tax on that profit which defeats the purpose of what many clients have asked me!
Detailed, accurate, and contemporaneous record keeping is also a factor the IRS consider when determining of you are operating a “for-profit” business or merely a hobby. An accurate and current set of business books demonstrates that you are actively monitoring the profitability of your business and evaluating all expenses. In other words, you have a true business motive in operating the activity.
The business is “non-passive” to the owner:
While there are many considerations, a general rule to follow is the 500-hour test. If you spend 500 hours per year on the activity, then you are materially participating in the activity. Depending on the type of business and other factors, this material participation could make the business “non-passive”. “Non-passive” losses are deductible against ordinary income.
The “passive” versus “non-passive” income and loss concept is one of the most scrutinized areas of the Internal Revenue Code. I highly advise consulting a tax advisor when determining if an activity is “passive” or “non-passive” before reporting a side business on your tax return.
Other considerations when starting a side business for the benefit of losses:
- Business structure that “passes-through” income, deductions, and losses to the business owner’s personal tax return: The (3) business structures that allow “pass-through” of the business to the personal return are 1) Single Member LLC, 2) Partnership, and 3) S-Corporation.
- The additional tax return filing and compliance rules to consider when operating one of the above (3) business structures.
Long story short, if you are starting a true “for-profit” business, then you should be aiming to make a profit which is ultimately taxable to you. You will be allowed to deduct all expenses and all losses against other ordinary income if you are actively involved as a “non-passive” owner of the business.
If you are starting a business only to create losses with no profit-motive, you will be creating a “Red Flag” on your tax return which could examined or audited by the IRS.
If you would like to discuss further any side business ideas and their tax consequences, please contact us for a free consultation. We will be happy to advise you on the details of this article along with many other considerations.
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