Risks of Not Reporting Business Income

There are many people who have businesses but don't report them because they are afraid of the IRS. This is a terrible idea. The most important thing when filing your taxes is to report all income, not reporting income can result in large penalties or even criminal charges! Plus having a side business is usually a good thing, as it can give tax benefits far beyond the income. This is because you get to write your business losses off against your income- and then write any additional loss off against other income.

Tips for reporting business income:

Is this really a business, or a hobby?

Be sure that your business can really be classified as a business and not a hobby. The IRS will audit you if you have really high losses, or carry losses on the same business for more than a few years in a row. If you lose money at something for too long they will come in and try to argue your business was really a hobby. If they succeed, your business will fall under the hobby loss rules where not only do you lose all the write offs against other income, but because of the way the income and deductions are reported on hobbies you will wind up paying a bit of tax on the hobby income. Businesses can be anything though- as long as the business activity is legal and the intention is to earn money. There was a case years ago with legitimate business losses being amounts a man paid prostitutes in Nevada for sex. How was this deductible? his losses were "research" because he was writing a book about legal prostitution. As far as I know he never made a dime off the book, but it was legal and legitimate as far as the tax court was concerned.

Logic behind profitization...

So the question then becomes how can you legitimize your business to protect yourself from this happening? The first thing that separates a business from a hobby is showing that you have potential and desire to profit at it. For example, if you're racing motorcycles just for the sake of racing motorcycles it is hard to show that you have profit making potential unless you're ten years old, but if you are racing motorcycles in order to advertise your motorcycle race engine building service then it becomes a whole different logic behind why you have to race.

Business Entitites

Another strategy to help legitimize a business is creating a business entity separate from the individual, a Partnership, LLC, or Corporation. The simplest to create is a partnership- you actually can form a partnership for last year until April 15th of this year! There is almost no cost to form a partnership, but once you form it you have to stay on top of filing returns for it or you can wind up with substantial penalties. LLC's and Corporations start getting more expensive to set up and maintain- especially in a state like California that charges a $800 minimum tax. But they have the added advantage of limiting liability in addition to creating a nearly bulletproof legitimate business structure. In the example above of the ten year old motorcycle racing champ I would probably recommend a family partnership for his racing business for a few reasons: one, the kid is too young to legally manage his money so it makes it more legitimate for him to be getting paid for his wins, and second, there is a good chance that someone that age can make it big time, and third the kid probably has little reason to need the write-offs from the racing losses, but the parents could probably use it against their income. It is common in Hollywood for people to set up these kinds of structures for their child stars,  or even for their pets that have film roles.

Good Record Keeping

If you keep detailed in clear records in a business like manner then you have a way better chance of your business proving itself. Financial records on Excel or Quickbooks are great, but not critical, hand written books are just as good. Things like keeping mileage logs in your car to keep track of miles driven for business are a great start. But more than that, when it comes to a business your records should show the plans you are implementing and how the business can turn a profit at some point. There is some great business plan software out there that makes it real easy to create a business plan, or I've used the templates in PowerPoint before just to make up a quick, easy business plan for either considering new business ventures or re-evaluating where one stands on current businesses.

 



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