Self-Employed Business Losses and the Profit-Presumption Rule

The question of whether an activity, such as freelance writing, is a hobby or a business arises when losses are incurred. Early business losses in any endeavor are not really all that unusual; however, that does not mean you shouldn’t be prepared to substantiate “your numbers” during an IRS field audit.

Normally, your self-employed business losses will be challenged as part of an IRS field (person-to-person) audit after a one-year significant loss or losses for two or three consecutive years.  To successfully sustain your losses:

  • You will have to prove that you are engaged in the activity to make a profit (“profit intent”), supported with a viable business plan [read my post “Professional Writer or Hobbyist?”], or
  • You may be able to take advantage of a “profit presumption” election to defer an IRS business/hobby determination until after you have completed the first five years in business.

Presumption of Profit-Seeking Motive

You are presumed to be engaged in an activity for profit if you can show a profit in at least three of the last five years, including the current year.  The presumption does not mean that losses will be allowed; the IRS may try to rebut the presumption. You would then have to prove a profit motive as outlined in “Professional Writer or Hobbyist?”

Profit Presumption Election Postpones Determination

If you have losses in the first few years of an activity and the IRS tries to disallow them as hobby losses, you have this option:  You may make an election on Form 5213 to postpone the determination of whether the above profit presumption applies.

The postponement is until after the end of the fourth taxable year following the first year of the activity.  For example, if you enter a freelance writing activity in 2012, you can elect to postpone the profit motive determination until after the end of 2016.  Then, if you have realized profits in at least three of the five years (2012-2016), the profit presumption applies.

When you make the election on Form 5213, you agree to waive the statute of limitations for all activity-related items in the taxable years involved.  The waiver generally gives the IRS an additional two years after the filing due date for the last year in the presumption period to issue deficiencies related to the activity.

To make this election, you must file Form 5213 within three years of the due date of the return for the year you started the activity.  If before the end of this three-year period you receive a deficiency notice from the IRS disallowing a loss from the activity and you have not yet made the election, you can still do so within 60 days of receiving the notice.  These election rules apply to individuals, partnerships, and S corporations.


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