Business expenses exceed my income significantly. Could I potentially be a target for an audit?

[Dflex CEO]

Hello Experts,

I find myself in a situation where my business expenses exceed my income significantly. Could I potentially be a target for an audit?

My husband works full-time, and I began freelancing two years ago. Despite securing a couple of projects and earning approximately $27k but my actual business net income was only $900.

Recognizing the need for a formal business structure, I established an LLC last year. Despite completing over three small projects, my expected income of $27k turned into $19k due to unpaid invoices. Complicating matters, I leased a new vehicle and incurred various expenses for business trips, resulting in a net loss of -$25k. The substantial expenses led to a $45k business deduction for the previous year. With two consecutive years of net losses, does this make me a likely candidate for an audit?

Thank you for your insights.

[DianeW777]

 It could lead to an audit.  In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business or for the production of income.  The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year. They also consider that a business start up may take some time to become profitable. You are not the first or last where profitability takes longer than expected. You must decide whether this is a hobby or a business and the following will help you.

Trade or business activities and activities engaged in for the production of income are activities engaged in for profit.   The following factors, although not all inclusive, may help you to determine whether your activity is an activity engaged in for profit or a hobby:  

• Does the time and effort put into the activity indicate an intention to make a profit?  

• Do you depend on income from the activity?  

• If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?  

• Have you changed methods of operation to improve profitability?  

• Do you have the knowledge needed to carry on the activity as a successful business?  

• Have you made a profit in similar activities in the past?  

• Does the activity make a profit in some years?  

• Do you expect to make a profit in the future from the appreciation of assets used in the activity?  

Hobby Key elements:

1. A hobby requires you to report the income you received and under the current tax law, Tax Cuts and Jobs Act (TCJA), no expenses are allowed to be used to reduce the money collected even if you itemize deductions
   1. Business or Hobby

[Dflex CEO]

Thanks for the detailed explanations! I used Quickbooks self-employed to track all my expenses. 

Part of the big deduction was my vehicle. $9269. I leased a new vehicle and added lease payments, insurance, gas, and mileage for the business. I used this vehicle 100% for the business and drove to the clients for meetings and local and out-of-state trade shows to pick up materials and find new material suppliers...

Also, expenses for traveling to China to attend the trade show and meet the suppliers for my project were a big part of the expense...  $14K and meals for$4000.

However, my client faced some issues and has not made scheduled payments... I think that made my deduction higher?...  

But I am worried this causing the audit....and no Idea what to do..