Monday, May 17, 2010

Travel As Business: Assessing the Risks of Taking a Business Loss for Your Travel Business

Turning your travel into a has several benefits, the greatest of which, obviously, is having your job (even it's only your side job) be something that you love.  Beyond that, though, it has the benefit of either generating profits for you if the business does well, or generating tax savings for you if the business does poorly .

But taking a business loss on your taxes does have a risk: the IRS determining that you are conducting a hobby and not a profit-driven business and penalizing you for that.  And since no one wants to end up in jail while trying to save money on their taxes, here is a blunt discussion of the risks involved in taking a business loss.

If you are audited, an IRS representative will try to determine if your loss is tax evasion or tax avoidance.

Tax Evasion

If you are evading taxes, you are risking a lot of grief. You could be jailed and you could be fined (the amount you owe plus a 75% penalty). If you are found guilty of evading taxes, there is no statute of limitations and and the IRS can look at your entire tax history when trying to assess how much you owe.  Obviously, no one wants to be guilty of tax evasion.

Tax Avoidance

Avoiding taxes is another matter. Provided it is legal, you are allowed to avoid as much tax as you can. One way to think about it is if you were to take a longer route home to avoid a toll road. Your effort has allowed you to legally avoid a tax and it was your right to do so.

An IRS agent might disagree with your interpretation of the law, but it is not illegal to take a tax avoidance position that later turns out to be wrong. In this case, the penalty is likely to be the amount you owe, plus 20%.

The statute of limitation on tax avoidance is three years. The IRS cannot recover money from a return filed four years before the audit, even if they determine that on those returns you were incorrectly avoiding taxes.

The Difference

As a CPA once told me: “Mess with the deductions, but never mess with the income.” Lying about income is considered tax evasion.  Taking a deduction that the IRS later considers incorrect, though, is usually a case of tax avoidance.

 Of course, if you are taking a deduction that you are clearly not entitled to (like taking an education deduction when you obviously weren’t going to school or taking a dependent deduction for kids that you don’t have), then that would almost certainly be considered evasion.

 But, as my CPA friend told me, taking a business deduction for an activity that you are making some money on is simply “taking a position. The IRS may later disagree with you, but it was not illegal.”

Chances of Being Audited

Even with Obama’s increase of funding to the IRS, the chances of you being audited if you report less than $100,000 a year is slim. The reason is that when the IRS chooses which cases to persue, they want the potential recovery to make up for the cost of the audit and then some. Most of the cases that are cited when
dealing with hobby-loss are for huge deductions. One was a doctor who tried to deduct his polo playing hobby because he met clients while conducting it. Another was for the owner of a car dealership who was deducting more than $30,000 a year for his stock car racing hobby because he said it helped advertise his dealership. In both cases, the courts disagreed.

 If you’re saving yourself $1,000 a year in travel deductions for your travel writing business, it’s hardly worth it for the IRS to spend almost that amount in payroll hours just to get it back.

That said, I firmly believe that you should take deductions as if you were to be audited.  Taking Schedule C losses is a red flag for the IRS, even if your deductions are too small to be worth the effort. Individuals also do get randomly selected, and you might get audited for that reason.

While it’s your right to avoid tax by taking business losses for a pleasurable business that you are trying to make a profit from, you should conduct that business as if the IRS will be investigating it.  That shouldn't deter you from doing it; it just means that you should be mindful when doing so.

Worth It?

That’s a question only you can answer, but here is a way to think about it: Let’s say you take business loss deductions that net you $1,000 in savings. That’s likely a significant amount of money for you. The chances of you getting audited are slim, but if it does happen and the decision goes against you, you will likely be penalized the amount you owe plus 20%. Since you would have paid the $1,000 if you hadn’t taken the deduction, your loss comes to $200.

That, too, might be significant, but it can help to think of that $200 as an investment. The chances of getting audited if you report $25,000-$50,000 on your tax return are 0.58%. So, would you be willing to invest $200 in a stock if you had a 99.42% chance of turning it into $1200?  Even in a casino, it would be a good bet: a 600% instant increase in your pocket with only the smallest chance of you having to give it back later.

Many others have agreed that it's a good bet, which is why Schedule C deductions loose the treasury $1.9 billion a year.  Because of this, the Treasury Department recommends fixing the tax code to make it harder to take a business loss for what may appear to be a hobby, but until that happens, taxpayers are allowed to turn their hobbies into businesses as long as they are trying to make a profit from them.

Disclaimer: I am not a tax professional, and can not be held liable for losses incurred while following the advice of this website.

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