When it comes to deducting expenses for a business with no income, the good news is the Internal Revenue Service (IRS) allows the deductions. The bad news is the IRS will not allow the deductions indefinitely. At some point, the business needs to show a profit. If it does not, the IRS views it as a hobby and does not allow deductions.
When it comes to determining if a business is a legitimate business or merely a hobby, the IRS employs various tests. The major test is whether the business has shown a profit for three of the last five years. This means a business has at least three years for business deductions before the IRS starts to question the legitimacy of the business.
An area where the IRS allows more leeway for business deductions without having income from the business is in horse races. While other businesses require the profit test of three of the last five years, for business owners involved with horses — showing, racing or breeding — the IRS allows for two out of the past seven years to determine if it is a hobby or a business.
When a hobby transforms into a business, prepare for the IRS to rear its ugly taxing head. When the business does not turn a profit, the business owner is fined. However, when the business begins to generate income, the IRS looks for its share. Keeping careful records is vital for later use when taxes come due.
Even if no income comes from a business, business expenses are deductible. It is important to ensure the deductions are acceptable by the IRS. The method the IRS uses to determine the validity of a business deduction is whether the item is considered common to the business in question and whether it is necessary. The IRS does not mandate an item be indispensable to be considered necessary, however. In other words, a computer printer for a business is considered necessary, although it is not indispensable. New business owners should remember items such as the cost of starting the business can be a business deduction, as well as advertising costs. In addition, even bad debts are deductible. In other words, if the business owner finds himself with a client refusing to pay, the owner has the ability to recoup some of the lost money by turning it into a business expense. In addition, self-employed business owners have the option of deducting retirement savings, even if the business did not have income for the year.
- AARP.org: Frequently Asked Questions -- Business Income and Deductions, Adjustments
- IRS.gov; Business or Hobby? Answer Has Implications for Deductions; April 2007
- Bankrate.com; Make Your Hobby Pay for Itself; Kay Bell
- IRS.gov: Business Expenses
- Portfolio; 10 Tax Deductions for Entrepreneurs; Teresa Novellino; April 2011
- Ryan McVay/Photodisc/Getty Images