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Daniel_284
Level 2

Is taking a deduction optional?

Hi there,

 

For a Schedule C sole proprietorship that has shown a loss in the first two years, if the third year is close to showing a profit can some business expenses simply not be taken as deductions? So as to not trigger the 3-of-5-years rule. 

 

Not reporting an expense, is there anything wrong with this?

 

How about for a depreciating business asset using a 5-year straight line method. Can you simply elect not to take a depreciation deduction for it in any given year? 

 

Thanks,

-Daniel

 

 

4 Best answer

Accepted Solutions
Mike9241
Level 15

Is taking a deduction optional?

the hobby loss rules are not just for years 1 thru 5, but 2 thru 6, then 3 thru 7 and so on. 

 

the IRS has to assert you have a hobby which you can refute by showing that the activity will eventually be profitable.  

 

not reporting all expenses to achieve a profit on which you would have to pay income and self-employment taxes doesn't seem wise. under the tax laws by overstating your profits you could end up with a tax benefit you are not entitled to and that can get you into trouble. why continue what is in fact a money-losing activity? 

 

you can elect the ADS system which usually stretches out the life and depreciation period but you can't skip a year. see IRS PUB 946. or maybe take section 179 which is not allowed until there is profit and only up to the amount of profit. unused amounts are carried forward.

 

https://www.irs.gov/pub/irs-pdf/p946.pdf 

 

 

View solution in original post

Critter-3
Level 15

Is taking a deduction optional?

Many valid businesses can show a loss every single year due to various factors like buying assets or inventory on credit, taking out loans, the rate of depreciation among other items.  So if you are running a business and trying to make a profit but your numbers show a "paper loss" then you don't have to worry.  Keep excellant records of all income and expensed in case of an audit. 

 

Read up on what the IRS says on this matter :   https://www.irs.gov/newsroom/heres-how-to-tell-the-difference-between-a-hobby-and-a-business-for-tax...

View solution in original post

Opus 17
Level 15

Is taking a deduction optional?


@Daniel_284 wrote:

Thanks. Perhaps I'm overly concerned about the 3-of-5 rule. The business is expected to be profitable, but whether that happens in year 3 is uncertain, in part because year 1 consisted only of a December. Perhaps better to keep everything accurately documented and deducted and be prepared to defend its business status if needed.

 

Your Section 179 note is also a good reminder, thank you.

 


The hobby loss rule is a rebuttable presumption.  If you can show by facts and circumstances that you really are actively engaged in ongoing business activities with a profit motive, you should survive any audit.  For example, in high school, my friend's Dad was running a "catering business" from his home, but it was really a hobby that he used to write off the purchase of fancy kitchen equipment for himself, and he had to  show a profit every once in a while.  (Obviously, being 14 at the time, I was not in a position to object.)  On the other hand, I doubt the IRS questioned the ongoing losses of amazon.com in its early days.  If audited, you would show by facts and circumstances that it really was a business with a profit motive.

 

I can't cite a specific regulation but I also believe that it is improper to fail to report expenses if that gains you a benefit you would not otherwise be entitled to.  The most obvious example is the earned income credit, where omitting legitimate expenses to create a profit could result in receiving more EIC than you pay in higher taxes.   Another example would be omitting expenses to show a higher profit for purposes of qualifying for a loan of some kind.  

*Answers are correct to the best of my ability at the time of posting but do not constitute legal or tax advice.*

View solution in original post

tagteam
Level 15

Is taking a deduction optional?


@Daniel_284 wrote:

Not reporting an expense, is there anything wrong with this?


This subject is open to debate with respect to taking various other deductions, but not with respect to net earnings from self-employment.


Revenue Ruling 56-407, 2 C.B. 564, addressed the issue of whether taxpayers may disregard allowable deductions in computing net earnings from self-employment for self-employment tax purposes. Rev. Rul. 56-407 held that under § 1402(a), every taxpayer (with the exception of certain farm operators) must claim all allowable deductions in computing net earnings from self-employment for self-employment tax purposes.

 

See also https://www.eitc.irs.gov/tax-preparer-toolkit/frequently-asked-questions/earned-income-self-employme...

 

 

 

With respect to the "3 out of 5" hobby loss rule, the presumption favors the taxpayer. In other words, if the activity is profitable in 3 or more taxable years out of 5 consecutive taxable years, then there is a rebuttable presumption that the activity is engaged in for profit. The opposite is not the case (i.e., there is no presumption that the activity is not engaged in for profit for any period unless the IRS establishes otherwise).

 

See Section 183(d).

 

 

View solution in original post

6 Replies
Mike9241
Level 15

Is taking a deduction optional?

the hobby loss rules are not just for years 1 thru 5, but 2 thru 6, then 3 thru 7 and so on. 

 

the IRS has to assert you have a hobby which you can refute by showing that the activity will eventually be profitable.  

 

not reporting all expenses to achieve a profit on which you would have to pay income and self-employment taxes doesn't seem wise. under the tax laws by overstating your profits you could end up with a tax benefit you are not entitled to and that can get you into trouble. why continue what is in fact a money-losing activity? 

 

you can elect the ADS system which usually stretches out the life and depreciation period but you can't skip a year. see IRS PUB 946. or maybe take section 179 which is not allowed until there is profit and only up to the amount of profit. unused amounts are carried forward.

 

https://www.irs.gov/pub/irs-pdf/p946.pdf 

 

 

Carl
Level 15

Is taking a deduction optional?

Not reporting an expense, is there anything wrong with this?

Yes. The IRS says you are required to claim all business expenses. Now I did a quick perusal of IRS Pub 535, and can't seem to find where it says that. I may have seen it elsewhere in a "tax topic" document maybe.

How about for a depreciating business asset using a 5-year straight line method. Can you simply elect not to take a depreciation deduction for it in any given year?

That I know you can't do. Anything used in business for the production of income that has a useful life of more than 1 year, is required to be depreciated, or expensed if the asset qualifies. At best, what you can do is convert the asset to personal use and remove it from business use entirely. That will stop the depreciation on that asset. But, if it's an asset that is ordinary/necessary for your business, you can probably expect to be audited on it anywhere from 24 to 36 months after filing. Otherwise, you'd darn well better "not" be using it in the business for the period of time it's not classified as a business asset - and you "may" have to prove it if audited/questioned on it.  Depending on the asset and it's classification, this method can have a pretty good chance of "raising flags" with the IRS. So I don't recommend it.

Keep in mind too, the IRS is hiring another 87,000 agents in addition to the 72,000 they already have. They're not doing that to go after the "rich" people.

Daniel_284
Level 2

Is taking a deduction optional?

Thanks. Perhaps I'm overly concerned about the 3-of-5 rule. The business is expected to be profitable, but whether that happens in year 3 is uncertain, in part because year 1 consisted only of a December. Perhaps better to keep everything accurately documented and deducted and be prepared to defend its business status if needed.

 

Your Section 179 note is also a good reminder, thank you.

 

Critter-3
Level 15

Is taking a deduction optional?

Many valid businesses can show a loss every single year due to various factors like buying assets or inventory on credit, taking out loans, the rate of depreciation among other items.  So if you are running a business and trying to make a profit but your numbers show a "paper loss" then you don't have to worry.  Keep excellant records of all income and expensed in case of an audit. 

 

Read up on what the IRS says on this matter :   https://www.irs.gov/newsroom/heres-how-to-tell-the-difference-between-a-hobby-and-a-business-for-tax...

Opus 17
Level 15

Is taking a deduction optional?


@Daniel_284 wrote:

Thanks. Perhaps I'm overly concerned about the 3-of-5 rule. The business is expected to be profitable, but whether that happens in year 3 is uncertain, in part because year 1 consisted only of a December. Perhaps better to keep everything accurately documented and deducted and be prepared to defend its business status if needed.

 

Your Section 179 note is also a good reminder, thank you.

 


The hobby loss rule is a rebuttable presumption.  If you can show by facts and circumstances that you really are actively engaged in ongoing business activities with a profit motive, you should survive any audit.  For example, in high school, my friend's Dad was running a "catering business" from his home, but it was really a hobby that he used to write off the purchase of fancy kitchen equipment for himself, and he had to  show a profit every once in a while.  (Obviously, being 14 at the time, I was not in a position to object.)  On the other hand, I doubt the IRS questioned the ongoing losses of amazon.com in its early days.  If audited, you would show by facts and circumstances that it really was a business with a profit motive.

 

I can't cite a specific regulation but I also believe that it is improper to fail to report expenses if that gains you a benefit you would not otherwise be entitled to.  The most obvious example is the earned income credit, where omitting legitimate expenses to create a profit could result in receiving more EIC than you pay in higher taxes.   Another example would be omitting expenses to show a higher profit for purposes of qualifying for a loan of some kind.  

*Answers are correct to the best of my ability at the time of posting but do not constitute legal or tax advice.*
tagteam
Level 15

Is taking a deduction optional?


@Daniel_284 wrote:

Not reporting an expense, is there anything wrong with this?


This subject is open to debate with respect to taking various other deductions, but not with respect to net earnings from self-employment.


Revenue Ruling 56-407, 2 C.B. 564, addressed the issue of whether taxpayers may disregard allowable deductions in computing net earnings from self-employment for self-employment tax purposes. Rev. Rul. 56-407 held that under § 1402(a), every taxpayer (with the exception of certain farm operators) must claim all allowable deductions in computing net earnings from self-employment for self-employment tax purposes.

 

See also https://www.eitc.irs.gov/tax-preparer-toolkit/frequently-asked-questions/earned-income-self-employme...

 

 

 

With respect to the "3 out of 5" hobby loss rule, the presumption favors the taxpayer. In other words, if the activity is profitable in 3 or more taxable years out of 5 consecutive taxable years, then there is a rebuttable presumption that the activity is engaged in for profit. The opposite is not the case (i.e., there is no presumption that the activity is not engaged in for profit for any period unless the IRS establishes otherwise).

 

See Section 183(d).

 

 

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