The IRS will want proof that you're a small business - Albuquerque Journal

The IRS will want proof that you’re a small business

I have four daughters. After numerous occasions where I was unable to notice that my wife or a daughter had been to a hairdresser, my girls nominated me for “least observant man in the lower 48.”

Who knew that was a thing? I came in second. It was later discovered that the winner had actually died three years earlier. His family refused to return the trophy.

I mention this because, during the COVID era, I seem to have developed superpowers. Always a walker, I began to take long walks in the areas surrounding my house. I noticed things.

I began to amaze family with specific tales of small businesses located in specific places. Others did not know these businesses existed.

Even I was amazed at the number of small businesses in my community. It turns out that, had I been a bit more curious, there are some very specific sources of data about small businesses.

There are, at last count, 31.7 million small businesses in the U.S. Each month, 543,000 new ones are added. To join the list, you must hire one employee for the first time.

The Small Business Administration seems quite at ease in identifying and classifying businesses. Not so much for the IRS and tax advisors.

The challenges facing tax people may be more perception than reality. We tax people deal with the definition of a business only when the thing in question may not be a business. So, unless they like to walk in the community, most tax people underestimate the number of businesses.

A tax person will tell you that a business is something that requires regular, continuous and substantial involvement. Why are tax people so hung up on such determinations?

It turns out that being a business allows for certain tax benefits not available to other things, even investment-type things.

First, deductions, if “ordinary and necessary” to that business.

Second, a special add-on deduction of 20% of the business income.

Third, if things go bad, a “net operating loss” to be carried either back to recover prior-paid tax, or forward to shield future income from tax.

There are also other benefits. The point is that the tax benefits cause the IRS to look at that business definition in ways the SBA might not.

There has been a trend for some time in people seeking out entrepreneurial pursuits that fit their passion. Labor economists tell us the pandemic has accelerated these trends.

Of those 543,000 new monthly businesses, most will never raise any tax classification issues. But some will. If you are a passion follower, take care to build a case that you have a “real” business.

How to do this? Show regular, continuous, substantial involvement. Do your homework before you leap into the abyss.

I learned from watching “Forensic Files” that most people accused of killing their neighbor first conduct extensive internet searches using the phrase, “how to kill my neighbor.” Computer experts search their hard drive.

The IRS will not engage experts to help you prove that you researched how to successfully run a particular business. That’s on you.

Trouble often ensues when the passionate person needs to hold down their current job until they can get the new venture off the ground. The activity is then part-time.

More trouble if the business is unusual. If you find yourself saying, “Two roads diverged in a wood and I, I took the one less traveled,” your trip in leaves no step had trodden black may raise an IRS attack (sorry, Mr. Frost, the original was clearly better).

Pre-COVID, my son-in-law’s best friend had a hobby: powerlifting. Stuck at home to work, he developed a new passion: macaroons. Oui, a colorful, but fluffy, French treat. Comme c’est excitant!

Current sales come from word of mouth. Next stop, the farmer’s market. Because an electrical engineering degree and years of powerlifting do not prepare one for fluffy French treats, he may experience early losses.

Document your research. Your time. Your sales efforts. How you moved along the learning curve to improve efficiencies. To the SBA you may already be a business. That may not be enough for those pesky tax guys.

Jim Hamill is director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.

 

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