Each month UPC Business Solutions will post important tax and business questions and answers. If you have an important question, please email us at the link below.

When can I start deducting business expenses? & Do I have to have a profit three out of five years to be deemed a business?

You are deemed to be in business and can, thus, deduct business expenses when you are open for business. Thus, you must be able to sell or service prospect. In your example, you note that you will not “start selling until next year.” Accordingly, you will not be able to claim any business expenses this year.

This also raises an important second issue. If you have a pre-opening expenses incurred before you start a business, you may not deduct these expenses. Thus, costs for legal and accounting fees, copyrights etc would be non-deductible. The IRS, however, gives you an out. You may elect to amortize your pre-opening expenses over a period of at least 60 months. You must elect, however, to do so on your tax return. See your accountant about making a protective election for your pre-star up expenses.

As to needing a profit in three out of the last five years, this is probably the biggest myth in tax law. Rightfully, you want to be construed as a business and not as a hobby. The implications are enormous. If you are in business, you get to deduct all ordinary and necessary business expenses on a dollar-for-dollar basis. In addition, if your expenses exceed your income, you will have a tax loss that can be used against any form of income such as wages, dividends, and pensions. It can even be used against your spouse’s earnings.

Example: Scott earns $40,000 in salary from his job. If his side business generates a $10,000 loss, he may offset the salary with the loss and pay tax on only $30,000.

If the loss from your business exceeds your yearly income, you may either carry back the loss two years or carry forward the loss twenty years and offset up to the next twenty years of income.

If you are a hobby, however, all expenses relaed to the hobby constitute miscellaneous itemized deductions, which must exceed a 2% of your adjusted gross income to be deductible at all. Moreover, deductions from hobbies are limited to the income from hobbies with no carryover or carry back. Thus, you rarely, if ever, want to be a hobby.

What are the rules for being a business?

The internal revenue code notes that if you have a profit for three out of five consecutive years (five out of seven for horses), you are presumed to be a business. However, even if you don’t have the necessary profit, you can still have many years of losses if run your business with the expectation of making a profit.

There are a number of factors that the courts use in making this determination. One of the biggest and most important factors is whether you have a business plan. This is a five-year projection of income and expenses. It should at some year in the projection show a profit. I cannot overstate the importance of this. You should also have a marketing plan built in to your business plan showing your projected marketing activities.

Another factor is whether you have the appropriate documentation. Businesses have correct detailed records. Businesses keep tax diaries. Hobbies do not. You should also work your business regularly. This means working your business at least 45 minutes per day, four or five days a week. It is much more beneficial to work a business four hours a week then to put in eight hours in one week and none in the second week.

Business owners go to training that should be documented. In addition, if business owners don’t have a profit in one year, they don’t repeat the same mistakes. Insanity is expecting different results doing the same thing. Business owners change marketing strategies if they don’t work and consult with experts.