Most People Are Not Aware That We Have Two Tax Systems.
One is for employees, which was created to take your wealth, and one is for small businesses that was designed to create economic growth. The reason is that small businesses generate over 70% of the job growth in this country. This is why Congress passes “good” tax laws (Yes, you heard me right, there are “good” tax laws) for small businesses. However, you must have a business to take advantage of these “good” laws.
If you have a side business and have the right knowledge, you can deduct part of your house, your kid’s education (no kidding), some of your vacation costs almost anywhere in the world, set up a pension plan that makes any government plan paltry by comparison and much more. Even better, if your business generates a loss, you can use that loss against any form of income such as your wages, pensions, rents etc.
There Is Catch However
The first catch is you must properly document your deductions.
The second catch is that you must run your business as a business and not as a hobby.
The following are some of the criteria that IRS and the courts look for:
How To Distinguish Between A Business And A Hobby
The IRS seems to love the “loss rule.” A person must have a profit two out of five years. In one of my tax law classes, the professor was determined to show that any business that did not show a profit in two out of every five years would lose all of the tax-deductions. I remember distinctively showing that this is only a misconception of the tax rules.
(From IRS Publication 535)
Generally, a hobby is an activity that is carried on for personal pleasure or recreation. It is not an activity entered into with the intention of making a profit. In determining whether you are carrying on an activity for profit, all the facts are taken into account. No one factor alone is decisive. Among the factors to consider are whether:
You carry on the activity in a businesslike manner
The time and effort you put into the activity indicate you intend to make it profitable
You depend on income from the activity for your livelihood
Your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business)
You change your methods of operation in an attempt to improve profitability
You, or your advisors, have the knowledge needed to carry on the activity as a successful business
You were successful in making a profit in similar activities in the past
The activity makes a profit in some years, and how much profit it makes
You can expect to make a future profit from the appreciation of the assets used in the activity
Killer Secret: To qualify as a business, you have to prove your intent to produce a profit.
We have all heard of Internet companies that have lost millions for years, Amazon.com being the best example we all know. If your goal is to take a loss, you have a hobby. If your intent is to create profit, then you have a business.
What You Can Deduct
The Internal Revenue Code allows you to deduct all “ordinary and necessary” expenses of operating your business — these can vary depending on the type of business. Understanding some of the terminology of the tax code will be crucial and the creating and keeping records related to reducing your tax liability.
President Clinton in one of his famous hearings made the following remark, which many of us deemed to be ridiculous, “It depends upon what the meaning of the word is “is”. What you “name” your deduction will often determine whether or not it is deductible.
(From the IRS Publication 535)
You can deduct business expenses on your income tax return. These are the current operating costs of running your business. To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business, trade, or profession. A necessary expense is one that is helpful and appropriate for your business, trade, or profession. An expense does not have to be indispensable to be considered necessary.
Killer Secret: Find ways to deduct expenses that occur every day for you!