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Proving a Business is ‘For Profit’

August 19, 2011 | Written by: Michael Crowther, Audit Representative
Tax Professional
One of the most difficult challenges we face when dealing with an IRS audit is arguing that a business is a ‘for profit’ activity instead of a hobby. If it is a valid business, a loss is allowed on the tax return. The IRS typically presumes an activity is a hobby if an initial review of a five-year period finds that the taxpayer does not have a profit in three of those years. When my taxpayer received an audit letter for his 2008 return, I knew we were in for a battle.

When I first contacted the member, he revealed that his Amway business had sustained losses for the last several years. Sure that the IRS would rule this a hobby for the simple reason that he had not yet turned a profit, I knew that the only way to win this one would be to argue that this activity was a valid business under Regulation section 1.183-2(b). This section of the code lists nine different facts and circumstances that can be used as a guideline to determine whether an activity is a business.

I quickly realized that the member did meet many of these tests. He carried on the activity in a businesslike manner with impeccable recordkeeping. He made sure to track all his income and expenses and keep all receipts. He met several other tests, but I felt that the most important argument here was to be able to show that the activity was progressing toward a profit through hard work and smart decision making.

I asked the member how his business had performed in 2009. He said there had been more sales, but it still had sustained a loss, although smaller than the loss in 2008. Next I asked about 2010, and the member said he hadn’t finished his tax return yet for 2010 because the year had just ended, but he thought there would be a net profit. Excited about this news, I asked if he could prepare a summary of his profit/loss for 2010, comparing 2008 and 2009 and showing how he had progressed toward a profit. He gladly accepted this assignment.

After several days I received the greatly anticipated summary. I reviewed it and found it to be just what we needed. It showed that in 2010 his business had a $2,000 profit! Also, the member explained in good detail the marketing strategies he had altered in order to cut down on travel expenses so he could focus on one specific area. It worked! He had cut down on his expenses and increased his overall sales. I congratulated the member on providing a great summary spreadsheet, and he was quick to give credit to his wife, who he said was the brains behind it.

I submitted our response to the IRS, arguing that this was a valid ‘for profit’ business and we waited several months for a response. Finally, the good news arrived: the IRS had accepted our argument and ruled the business a ‘for profit activity’ and they were not making any changes to the return. I emailed the member with the news and he replied, “Wow Michael!!! This is great news! Thanks a lot for your help all along. Couldn’t have been possible without your suggestion of attaching a summary sheet.”

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