Protect Your Business Losses by Incorporating

How to Fight the Hobby-Loss Rule

Businessman working in office with stacks of paperwork
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If the net profit figure on your Schedule C is a negative number, you have a business loss. The vast majority of freelancers incur losses. This is how losses work.

First, your business loss reduces your total income. On Form 1040, your total income is calculated on Line 22. The loss also reduces your Adjusted Gross Income (Line 36), and Taxable Income (Line 42). As such, your business loss reduces your income tax.

If you have a day job (on a W-2), this means you will get a bigger refund compared to someone who earned the same amount of wages but did not have a freelance gig side business.

Reducing your taxes in this way is an excellent tax strategy. In fact, many tax professionals have encouraged people with high incomes to convert their hobbies into "businesses" so they can have a loss to reduce their income. Not surprisingly, the IRS has caught on to this strategy.

There's no hard-and-fast method for distinguishing between a hobby and a real business just based on the tax return. After all, the tax return is just a piece of paper, and so there's no way to tell a legitimate business from a hobby apart except by using a rule of thumb.

Hobby Loss Rule of Thumb

If a business reports a net profit in at least 3 out of 5 years, it is presumed to be a for-profit business. If a business reports a net loss in more than 2 out of 5 years, it is presumed to be a not-for-profit hobby.

This rule of thumb makes places a huge burden of proof on young businesses. On the one hand, the IRS expects new businesses to incur a loss. It is normal for a business to have a year or two of losses before becoming profitable. On the other hand, it is likely that a business could have several years of losses before ever making a profit.

In fact, several such cases have been sent to the Tax Court.

If you cannot meet the 3-out-of-5 year rule (3 years of profits in a 5-year period), you can still prove your profit motive using the following nine factors:

  1. You carry on the activity in a businesslike manner,
  2. The time and effort you put into the activity indicate you intend to make it profitable,
  3. You depend on income from the activity for your livelihood,
  4. Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
  5. You change your methods of operation in an attempt to improve profitability,
  6. You, or your advisors, have the knowledge needed to carry on the activity as a successful business,
  7. You were successful in making a profit in similar activities in the past,
  8. The activity makes a profit in some years, and how much profit it makes, and
  9. You can expect to make a future profit from the appreciation of the assets used in the activity.

This list is found in IRS Publication 535 Business Expenses.

An audit to defend your business losses can be a very expensive audit. If you lose, the IRS will disallow the loss. Your business expenses will be limited only to the extent of business income (which means zero profit).

And you will have to re-calculate your tax liability, often meaning that you will have to repay some of your income tax, plus penalties and interest. The audit may also be a waste of time and money, since you will have to spend time-fighting the IRS and paying an accountant, instead of focusing on making money.

Nonetheless, defending your business loss is in your best interest, because creative professionals have succeeded in demonstrating a profit motive despite years and years of losses. First and foremost, you must carry on your freelance work in a very businesslike manner. This means keeping good records, keeping a business diary showing meetings with clients, deadlines, and projects, having business cards and a website that promotes your business, and keeping a log of freelance gigs you apply for, and so forth.

If you arrive at your audit armed with a daily planner showing all this information, it will be harder for the IRS to prove that you were just a hobbyist.

The hobby loss rule-of-thumb applies to sole proprietors filing a Schedule C. One of the surest ways to prove you are serious about doing business is to form a separate business entity. Businesses are separate entities for tax purposes. Setting up a business for your freelance writing will provide a way for you to separate your personal income and expenses from your business income and expenses.

If you decide to incorporate, there are several varieties of business entities you can choose from, each with its own tax structure.

C-Corporation. Regular corporations are sometimes called "C-Corps" to distinguish the regular corporation from a newer counterpart, the Subchapter S Corporation, or "S-Corps." Regular corporations are completely separate entities. They have their own tax identification number, and they file their own tax returns. If a corporation has a loss, that loss carries forward to offset next year's profits. Corporations can have several years of losses, and the accumulated losses carry forward to offset future profits. Entrepreneurs can realize significant tax benefits by forming a corporation. Let's say Mary, a freelance writer, has a loss in year 1 of $10,000, followed by a loss in year 2 of $5,000. In year 3, Mary's company makes a profit of $50,000. The accumulated losses will reduce that profit to only $35,000. Mary cannot deduct these business losses on her personal tax return. The losses are retained by the company and are used to offset future profits.

S-Corporation or Partnership. These are called "pass-through entities." Basically, these businesses are not taxed at the corporate level. Instead, any profit or loss is "passed-through" to the shareholders. The shareholders report the profit or loss on their personal tax return. That means all profits are taxed on the shareholders' tax returns. If an entrepreneur has at least one other business partner, they can form a partnership. If there is the only one shareholder, an S-Corp can be formed. Both S-Corps and Partnerships report their profit or loss on a business tax return, but issue Form K-1 to each shareholder to report the shareholder's share of profit or loss. Let's say Mary, a freelance writer, forms an S-Corp, with the same losses as the regular corporation above Year 1 loss of $10,000; Year 2 loss of $5,000; and Year 3 profit of $50,000. In year 1, Mary would report her loss on Schedule E, and the loss would reduce her total income. In year 2, likewise, the loss would reduce Mary's total income. In year 3, Mary would report a profit, and her total income would increase. Partnerships and S-Corps cannot retain their own profits or losses, and so the profit in year 3 cannot be reduced. That's because the losses were already distributed to the shareholders. There is one significant audit risk with a partnership or S-Corp. It is assumed that the shareholder works for the S-Corp or partnership, and so the IRS expects part of the shareholder's income will be taxable wages, and part will profit from the business. In order to avoid an audit, Mary would have to pay herself a reasonable salary, and pay tax on the salary, even though the business isn't making any money.

Limited Liability Company. Much has been written about the Limited Liability Company or LLC. The LLC is designated by the state where the business incorporates. The LLC is not a federal tax entity. An LLC is taxed as a partnership at the federal level. Or, if the LLC chooses, it is taxed as a C-corporation. If the LLC has one and only one shareholder, the LLC may be a "disregarded" entity and taxed instead on the 1040 Schedule C.

Forming a separate business entity is one way to show that you are serious about making money in your business venture. IRS Publication 535 "Business Expenses" implies that the hobby loss rule-of-thumb also applies to Partnerships and S Corporations. (I haven't heard of audits on partnerships and S corporations that focus on profit motive, but perhaps this is a direction the IRS might move in.)

Loss Strategies. If you have been filing a Schedule C and have already used up your 2 years of losses, you should consider whether forming a separate business will protect your losses. In protecting your losses, you must take into account the added cost of a potential IRS audit (even if you succeed in defending yourself), plus the added cost of incorporating in your home state.

In general, if your business activity is expected to be profitable over the long-term, I recommend forming a regular C-corporation. Current losses will reduce future profits. The IRS has explicitly said that the 3-out-of-5 year rule does not apply to C-corporations.

In general, if your business activity is expected to generate losses for the foreseeable future, I recommend forming a partnership or an S-Corporation. Current losses will reduce current income on your 1040. Future profits, if any, will not be reduced by previous losses. In order to form a partnership, you will need at least two shareholders. This could be a spouse, significant other, or really any other person. And it doesn't need to be 50-50. Your partner could own as little as 1% of the partnership.

Of course, you can continue to report your losses on a Schedule C. There are no additional costs to bear in incorporating your business. However, you must prepare yourself for the potential cost of an IRS audit. You can prepare yourself by keeping a business diary in a daily planner, keeping excellent records of your income and expenses, and conducting your freelance work in a very business-like manner. This means promoting your business, competing for contracts and other freelance gigs, maintaining an office, having regular hours of operation, and separating business expenses from personal expenses.

Let's compare the three main forms of business entities available to a freelance entrepreneur running his or her own business. Here's our scenario: Mary is a freelance writer who expects several years of losses before turning profitable. Mary is employed full-time, and her income puts her in the 25% tax bracket. Mary is the only shareholder in her business, so we have ruled out the possibility of forming a partnership. (If Mary could find a business partner, the situation would be similar to the S-Corp scenario, except that Mary would multiply the business profit by her percentage in the partnership.)

Comparison of the 3 Business Entities for Year 1

In Year 1 of her business, Mary suffers a business loss because her expenses exceeded her income. Mary had business income of $30,000 but expenses of $40,000.

Schedule C
Business Income: $30,000
Business Expenses: $40,000
Salary Expenses: $0
Payroll Taxes: $0
Profit or Loss: -$10,000
Result: Filing on a Schedule C will reduce Mary's taxable income by $10,000. If Mary is in the 25% tax bracket, this could reduce her tax by $2,500.
Change in Total Taxes: -$2,500.

C-Corporation
Business Income: $30,000
Business Expenses: $40,000
Salary Expenses: $10,000
Payroll Taxes: $765
Profit or Loss: -$20,765
Result: The loss is retained by the corporation and offsets next year's business income. The loss is increased by the wages that the Corporation should pay Mary for her services and by payroll taxes on those wages. Mary's income is increased by $10,000. If Mary is in the 25% tax bracket, Mary's tax is increased by $2,500. Mary also pays an additional $765 for her share of Social Security and Medicare taxes.
Change in Total Taxes: $3,265.

S-Corporation
Business Income: $30,000
Business Expenses: $40,000
Salary Expenses: $10,000
Payroll Taxes: $765
Profit or Loss: -$20,765
Result: The loss reduces Mary's taxable income by $20,765. The loss is increased by the wages that the Corporation should pay Mary for her services and by payroll taxes on those wages. Mary's income is also increased by $10,000 in additional wages. Mary's income has a net decrease of $10,765, and a net tax savings of $2,691 at the 25% tax bracket. Mary also pays an additional $765 for her share of Social Security and Medicare taxes.
Change in Total Taxes: -$1,926.

Comparison of the 3 Business Entities for Year 2

Given her economic situation from year 1, Mary decides to control costs in year 2 and maintain her existing contracts. Mary succeeds in holding business expenses at $15,000, and holding her business income steady at $30,000, giving her a tentative profit of $15,000 for the year. The real power of choosing the right business entity becomes clear when an unprofitable business suddenly becomes profitable.

Schedule C
Business Income: $30,000
Business Expenses: $15,000
Salary Expenses: $0
Payroll Taxes: $0
Prior Year Loss Carried Forward: $0
Profit or Loss: $15,000
Result: Filing on a Schedule C will increase Mary's taxable income by $15,000. If Mary is in the 25% tax bracket, this would increase her tax by $3,750. Also, Mary will have to pay Self-Employment Tax (15.3%) on her business profit, an additional $2,295. In order to avoid owing an additional $6,045 on April 15th, Mary should make four estimated tax payments of $1,511 each quarter.
Change in Total Taxes: $6,045.

C-Corporation
Business Income: $30,000
Business Expenses: $15,000
Salary Expenses: $10,000
Payroll Taxes: $765
Prior Year Loss Carried Forward: -$20,765
Profit or Loss: -$16,530
Result: Filing as a C-Corporation will decrease the Corporation's tax in year 2 because the loss from year 1 is carried over into year 2. Unlike the Schedule C or S-Corp, the loss is not distributed to the owners, and so it offsets next year's income. Because the Corporation has a net loss, there is no federal income tax. Just like in year 1, Mary's income is increased by $10,000. If Mary is in the 25% tax bracket, Mary's tax is increased by $2,500. Mary also pays an additional $765 for her share of Social Security and Medicare taxes.
Change in Total Taxes: $3,265

S-Corporation

Business Income: $30,000
Business Expenses: $15,000
Salary Expenses: $10,000
Payroll Taxes: $765
Prior Year Loss Carried Forward: $0
Profit or Loss: $4,235
Result: Business profits are reduced by the addition of salary and payroll taxes that must be paid to Mary. The profit increases Mary's taxable income by $4,235. Mary's income is also increased by $10,000 in additional wages. Mary's income has a net increase of $14,235, and a net tax increase of $3,559 at the 25% tax bracket. Mary also pays an additional $765 for her share of Social Security and Medicare taxes.
Change in Total Taxes: $4,324.

Your Situation

Your tax situation will be different than the scenario with Mary. Nonetheless, this scenario demonstrates a couple of crucial points. First, even a modestly profitable business (such as Mary's in year 2), can get blindsided by the cumulative effect of regular income taxes and the Self-Employment Tax. For this reason, alone, I urge entrepreneurs to incorporate their business as soon as they reasonably expect their business to turn profitable. Second, S-Corporations (or partnerships if you can find additional shareholders) offer a middle ground between Schedule C and regular C-Corporations. Paying yourself a salary in an S-Corp, which sounds like a disadvantage, has the effect of increasing losses and minimizing profits.

Your personal decision on the matter should be made after weighing factors such as your other income, your marginal tax bracket, expectations of future profits, and your personal tolerance for record-keeping and dealing with the IRS. (Incorporating requires more paperwork, but remaining a Schedule C means higher chances of being audited.)