Expenses when operating at a loss

[ktax2]

(Posted this a few hours ago, but didn't get a reply, so trying again.)

I've been self-employed for thirty-plus years and have always operated at a profit until 2021, due to setbacks from the pandemic. This year I will have more business expenses than income to report. Is this something I should be concerned about? I would still like to deduct the expenses, and not have my business downgraded to a hobby, as it is my sole source of income (via different 1099 jobs). Thanks!

[HollyP · Accepted solution]

No. This is not a problem at all. You are required to report all your expenses and all your income when you are self-employed even if that means that you show a loss. Additionally, you should not downgrade your business to a hobby just because your business in not profitable in a particular year. The IRS has a safe harbor rule that if you have turned a profit in at least three of five consecutive years, the IRS will presume that you are engaged in a business for profit. Please see When the IRS Classifies Your Business as a Hobby  for more info. 

I'll look for your other question as well now and see if you still need help there. Thanks for posting again!

[ktax2]

It was the same question! Thank you so much for the reply, Holly. That is a relief. Thanks for the document also.

[VolvoGirl]

But Some expenses, such as home office or section 179 depreciation can only be used to reduce your schedule C taxable income to zero, and not to create a loss. Excess deductions for these carry over to the next year.  And you have to answer yes to both questions about exclusive and regular use, not just one.  The area of your home office must be used regularly and exclusively for business to deduct it.

[HollyP]

You're welcome @ktax2!

And @VolvoGirl makes a good point that some losses are not allowed if they reduce your business profit below zero, like a home office or self-employed health insurance,  but they just get carried over and are deducted when you business shows a profit.

But again, don't worry, TurboTax will walk you through all that when you complete your return.

[ReneeTAXEA1]

Hi there!  I wanted to weigh in as our colleague Holly's suggestions to you were right on the money!!

I did want to mention to you - to assist you in putting the 2021 tax year business loss into proper context - that - typically, if a small business continues to run at a loss (meaning expenses are higher than income repeatedly) the IRS will become interested within 3 - 5 years.

When they do, the business may get reclassified as a hobby if the business owner can't prove he is really trying to make a profit.

Earning a profit

The IRS expects that if you start a business, you intend to make money at it. If you don't, your business might be a hobby. To determine if your business is a hobby, the IRS looks at numerous factors, including the following:

• Do you put in the necessary time and effort to turn a profit?
• Have you made a profit in this activity in the past, or can you expect to make one in the future?
• Do you have the necessary knowledge to succeed in this field?
• Do you depend on income from this activity?
• Are your losses beyond your control?

Practical standard for business classification

The IRS safe harbor rule is that if you have turned a profit in at least three of five consecutive years, the IRS will presume that you are engaged in it for profit. This may be extended to a profit in two of the prior seven years in the specific case of horse training, breeding or racing. This is, presumably, because these endeavors involve a great amount of risk.

Consequences of hobby classification

Generally, the IRS classifies your business as a hobby, it won't allow you to deduct any expenses or take any loss for it on your tax return.

If you have a hobby loss expense that you could otherwise claim as a personal expense, such as the home mortgage deduction, you can claim those expenses in full.

For tax years prior to 2018, other expenses, such as advertising, wages, insurance premiums, depreciation or amortization, may also be usable as an miscellaneous itemized deduction subject to 2 percent of your adjusted gross income. However, you must have earned more total income in your hobby than the amount of all of these deductions, including your personal deductions. In that scenario, it's likely the IRS would categorize your hobby as a business anyway.

Beginning in 2018, miscellaneous itemized deductions are no longer deductible and therefore no hobby expense is able to reduce hobby income.

Preventing your business from being classified as a hobby:

Running a hobby as a business could very possibly trigger an IRS audit. If your business is legitimate, keeping accurate and extensive records could help prevent the classification of your business as a hobby.

In addition to demonstrating your professional approach to your business, records and receipts can help document your profit motive. A written business plan is often a prerequisite for indicating an intent for profit, and it can also show ways in which you are modifying your business to cope with losses.

[ktax2]

Thank you, Renee! Fingers crossed I will be back to making a profit in 2022 and this will be my only year without a profit. But it's good to know I have some leeway if business is slower to come back than I'm counting on... 🙂

[ReneeTAXEA1]

Thank you for your reply!!  Those were kind words.  Have faith, and we truly wish you well and are cautiously hopeful that things will turn around and get better!!  Good luck to you!

[Critter-3]

2020 & 2021 were bad years for many many businesses and they will understandably show a loss for those tax years and the IRS will have to be understanding due to the covid situations ... I am sure many things will be allowed like landlords with massive losses on a Sch E and Sch C losses ... so don't worry about it.  Just keep good records like you always have to do and file a true and accurate return then you have nothing to worry about.