Are you running a business? According to the IRS, the answer to that question largely depends on the records you keep. It’s not just what you do, but how you do it, including keeping independently auditable records that detail profit and justify expenses.
If you fail to keep those records, the IRS could very well determine that you have a hobby and not a business, disallowing any deductions you may claim. In fact, how you conduct your business, including keeping accurate books and records, is the first and most important factor the IRS considers when evaluating your activity. Your records must support that your entity is profit-driven, your expenses are “ordinary and necessary,” and that you have some continuity of operations.
This is especially important as many businesses are recovering from the impact of the COVID-19 extended emergency, impacting profits and making them more vulnerable to being flagged for an audit. And while small business owners have all struggled with the significant challenges that come with the “many hats-little time” syndrome, losing your mind once a year trying to get your records in order is a sure-fire recipe for creating even more headaches. Not only does it increase the likelihood for errors, but incomplete books could cost you significant money at tax time or, worse, make you vulnerable for additional scrutiny by the IRS.
If you do find yourself and your business on the wrong end of an IRS decision that disallows your expenses because of a hobby determination, the odds aren’t in your favor. One Forbes article noted that of 14 hobby loss decision appeals in 2019, only two were won by the taxpayer.
The IRS does have reason to look closely at businesses and how they operate. Consider the case of the banker who owned a cattle farm with no cattle and ran timber operations with no timber management plan or revenue (Whatley vs. IRS, 2021). The IRS did not look kindly on his claimed $.5 million in losses over five years, and the court agreed.
But of course, you are running a legitimate business. You just need to make sure you have the records to prove it. Getting in the record-keeping mindset will actually save you significant time and headaches in the long run. It’s a binary world. Either you can independently prove something or you can’t. If you can’t, it doesn’t exist.
And while the IRS is very clear on what can get you into hot water, there is no prescribed record keeping system. However, implementing a simple, comprehensive system doesn’t have to be difficult. First, you’ll want to capture the needed information at the time of the transaction, whether profit or expense. Don’t assume you’ll remember critical details, because you won’t. Note the date, the amount, and the purpose. Make sure transactions are regularly recorded and stored where you and your bookkeeper can access them. Finally, regularly review your financial data to assess how you’re doing and what business decisions or adjustments you may need to make.
The key is to have a system, and make it a daily habit. Then, when you need your financial data, whether for internal business decisions or to respond to external demands, it will be there and ready.
Note: Separate business entities such as corporations are not subject to the provisions of IRS Revenue Code Section 183 governing the characterization of businesses vs. hobbies. However, sole proprietorships, partnerships, LLCs, and S corporations are.