Getting a business off the ground takes time, and the IRS recognizes this. In your first few months or year of operation you may not bring in any income. Even without income, you may be able to deduct your expenses, as long as you meet certain IRS guidelines. Your business loss can offset other income on your tax return and lower your overall tax bill. The test for being able to deduct your expenses is whether you are operating a true business and not practicing a hobby.
Business vs. Hobby
The IRS presumes you are conducting a business, rather than a hobby, if you report a profit in three out of the previous five years. So you could operate your first two years without a profit, though no income at all in two years might cause auditors to take a closer look. But even if you show no profit for several years in a row, the IRS may allow your deductions if you can show other evidence that you are conducting a business. For instance, if you conduct your affairs in a business-like manner and devote time and effort toward making the business profitable, if you’ve made a profit in similar activities in the past, if you are trying to make a living and support yourself with the business, or if your failure to bring in income is due to circumstances beyond your control, the IRS may acknowledge that you are conducting a true business and allow your business expense deductions.
You can use your business loss to reduce your adjusted gross income, subtracting the amount of the loss from income you realize from investments, paid employment or another business you operate. If you don’t have any taxable income, you can’t use the loss from your business to generate a refund. If your loss exceeds your income from other sources, you can only deduct up to the amount of your income. You can, however, carry over the excess loss and apply it to the subsequent year’s tax bill.
To prove your intention of operating a business, despite a lack of income, you need to not only keep good records of the expenses you claim, but any documentation that supports the deduction as necessary to conduct your business. Examples of records that may prove useful include calendars and datebooks that show the amount of time you spent on business activities, and the kinds of tasks you did in an attempt to make your business profitable. Examples of other businesses in your field that had a slow start but were eventually profitable would be helpful, as would copies of ads you took out, your business plan and anything else that shows an intent to make a profit from the business.
If you don’t have any income in your first year of business, you have the option of filing Form 5213 – Election to Postpone Determination as to Whether the Presumption Applies That An Activity is Engaged in For Profit. This postpones any IRS assessment of whether you are conducting a business or a hobby until the fourth year you are in business. This gives you time to show a profit in three of five years.
Deductions Not Allowed
If the IRS determines you were not conducting a true business, you will not be allowed to deduct your business expenses. If you file Form 5213, the IRS will wait until your fourth year in business to make this determination, but it may disallow deductions on the tax returns you filed in years one through three and you could owe taxes and interest on those returns.
Cynthia Myers is the author of numerous novels and her nonfiction work has appeared in publications ranging from "Historic Traveler" to "Texas Highways" to "Medical Practice Management." She has a degree in economics from Sam Houston State University.