Don't Let the IRS Reclassify Your Business as a Hobby

Artists, photographers, travel writers and horse breeders might seem to have fun businesses, but not where the Internal Revenue Service is concerned.
If you're a sole proprietor filing a Schedule C in industries that are generally seen as recreational such as quilting or jewelry making, and your business hasn't made a profit in at least three of the past five consecutive years, the IRS may audit your business and reclassify it as a hobby. (For horse breeders and trainers, the rule is at least two of the last seven years must be profitable.)
With tax time around the corner, a number of struggling businesses may fall into this predicament -- after the worst recession to hit the U.S. since the Great Depression laid siege to many small companies' finances.
If your business gets reclassified as a hobby, you may be forced to kiss some valuable tax deductions goodbye. For instance, you could lose your ability to write off business losses and expenses against other income from, say, a day job. What's more, since the IRS can go back three years in an audit, you may face a really big tax bill as well as the inability to write off losses from your “hobby” in the current tax year and into the future.
A lot of owners assume this reclassification is automatic -- that having more than three years of losses in five consecutive years or three consecutive years of losses will blow you out of the water no matter what. Fortunately, they're wrong. It's not automatic. Instead, if you are selected for an audit, the IRS will typically give you a chance to prove your profit motive and whether your fun business is a legitimate enterprise.
Here are nine tips for helping persuade auditors that you're serious about running and building a business -- and not just playing at it:

1. Keep a set of books -- preferably on accounting software or on a spreadsheet. Generate profit-and-loss statements and comparative profit-and-loss statements to measure the growth of your business against prior years. Chart future projections, and write a plan for turning the business into a profitable enterprise. Keep all your notes and financial statements to present during an audit.
2. Be in compliance with local, state and federal requirements by obtaining all required licenses, insurance and permits. Maintain a file of all certificates and licensing information to present during an audit. 
3. Keep a mileage log or at least an appointment book to substantiate any automobile deductions. Follow the rules for deducting commonly flagged expenses like travel, meals and entertainment.
4. Improve your skills. Attend classes, trade shows and conventions. Keep all registration forms and fliers to prove your attendance and the nature of the event.
5. Open a separate business bank account. Deposit all sales revenue into this account and pay all business expenses from this account. If you don't have enough sales revenues to cover the expenses, don't start paying business bills from another account. Instead, transfer funds from your personal accounts to cover the bills. 
6. Advertise. Keep copies of every advertisement you place. During an audit, these records will go a long way toward proving that you're serious about the business.
7. Network. Get out there among your peers and exchange ideas. You can do this by joining a local chamber of commerce and other professional organizations. 
8. Do some thinking. Be ready to explain to the IRS why your business is a serious enterprise. Perhaps you're nearing retirement and are looking to turn a part-time venture into a full-fledged business? And why exactly aren't you showing a profit? The recent recession is a good reason many businesses aren't moving forward. And there is nothing wrong with admitting that you're having trouble getting the hang of being a good businessperson. After all, entrepreneurial skills are often acquired. 
9. Stand your ground. If you're being audited, and you find yourself on the losing end of the argument, stop the audit. Tell the auditor that you need to discuss the matter with a tax professional before you continue. The auditor must honor your request and give you adequate time before resuming the audit.