What happens when a taxpayer files a tax return showing $0 of business income, offset by $58,000 of business expenses? They usually get audited. Especially when they have income from other sources of over $100,000. And if the taxpayer pursues the case to Tax Court, the Court usually sides with the IRS. Such was the case Thursday for a taxpayer from Maryland.
The taxpayer worked full-time as an oceanographer for NOAA and taught college classes part-time. His income for 2004 (the year being audited) was $120,000. The taxpayer offset this income with $58,000 of business expenses (with $0 of business income) for a photography business. The expenses related mostly to three trips he took to Europe to “build his portfolio.”
The IRS disallowed the expenses on the grounds that the taxpayer had no profit motive and thus didn’t have a business. The Tax Court agreed:
Wilmot relied on word of mouth to promote his activity even though he had few contacts and no established reputation in the photography industry. He claimed that he had contacted several potential clients in 2004, but we find that he contacted only three potential clients; and of these, only one was a realistic prospect. He even turned down work that he thought undesirable: he declined to work on photography jobs with another Montgomery College student who did personal portraits and wedding photography. We are skeptical that a fledgling for-profit photographer would have behaved this way.
We can take away two key points from this ruling.
First, treat your side business like a business. My clients with side businesses know that I often say this. If it’s really a business, treat it that way, not just as an excuse to get tax writeoffs.
Second, a side endeavor can be considered a business one year and not a business in a different year. For example, the IRS audited this taxpayer’s 2006 return and determined that his photography was a business. But that was irrelevant to whether it was a business in 2004. Each year is considered separately.*
Click here for the full text of the Court ruling.
*-A taxpayer’s history of net income or net losses from the endeavor is taken into account when determining if an endeavor is a business. But the fact that an endeavor was determined to be a business one year is not a factor in determining if it is a business in another year.