3 out of 5 Test

By Jason Watson (Google+)

By generally accepted definition, if you are profitable 3 out of the last 5 years your activity is automatically considered a legitimate business. Essentially turning a profit is the best way to show your profit motives (sorry for stating the obvious). There isn’t a profit threshold or a percentage that the IRS is looking for. Just being profitable, even a few bucks, is going to check the profit box and count towards your three out of five years.

Not to worry, you can still demonstrate a profit motive. Remember, the 3 out of 5 test presumes a business if there is profit. If you cannot pass the 3 out of 5 test, you are presumed to be operating a hobby unless you can prove a profit motive.

There are several reasons why legitimate businesses might not be able to show a profit for 3 years- some businesses take more time to materialize their profit, and others might be victims of horrible economic conditions (e.g., a concrete contractor waiting for the housing industry to pick back up).

Three choices exist:

1. You could go dark, and stop deducting the business losses for a couple of years (this is not our recommendation), or
2. Deduct your business expenses up to the amount of your business income for a net zero affect (this is similar to gambling losses, which can only be deducted to the amount of gambling winnings), or
3. Press on and make your argument during a possible audit.

Here are some suggestions for demonstrating that your business is for real and not a hobby-

Keep Good Records
The Tax Court relies heavily on your businesslike behaviors to help determine your profit motives, and one of those behaviors is recordkeeping. In their eyes, businesses with a profit motive maintain good records so you should track revenue and each expense with as much detail as possible. Maintain a separate checking account for your business related transactions. Were you once profitable, but are currently experiencing several years of challenging times? Be able to show your financial history beyond the five year mark.

Prove Your Advertising
How many legitimate businesses don’t advertise? Not many. So, keep copies of your advertisements, business cards, flyers, letterhead, logo artwork, etc., and all the associated expenses (web development, graphic artist fees, etc.).

Track Your Actions
Use a business calendar app or something similar to show your actions, and how they are related to your eventual profitability. Who did you meet with? What publications did you read? Do you have a mentor? What type of training are you receiving? Conferences? How many hours per week are you spending on your activity?

Be Legit
Make sure you have all the permits and licensing required for your business. Create an LLC (we can help). Register your business in local directories.

IRS Regs
Review the items listed under IRS Regulation 1.1283-2(b), and be in compliance with those items.

Again, your actions are going to speak much louder than your words. The next KB article is a summary of a Tax Court case docketed October 25 2012 which shows how a taxpayer with eight consecutive years of losses was able to demonstrate that his business was trying to earn a profit. Eight!