Is it sufficient to try and show I'm trying to make a profit? Do I have to pay myself wages and what if I can't ever live off of the profits fully?
The hobby loss rule grew out of abusive tax shelter schemes, as for example buying a horse for your daughter and then using the horse in a farm business as an excuse to write off the cost of your 20 acres weekend retreat where the horse is kept.
You didn't go into business to lose money, but to make money, right? Focus on your business. Yes, S-corps do require that you pay yourself reasonable compensation. If the business does not generate sufficient profits for you to live on, you might have to keep your day job for a year or two. However, as a practical matter if in 3 years your business is still losing money, maybe you should rethink the whole idea. Not even GM can lose money forever.
The S-Corp is not an ideal entity for many people. Talk to a local lawyer about organizing your business as a Limited Liability Company. This should give you more flexibility. Good advice now can save you from headaches later on.
Good luck with your venture.
Please keep in mind that there are many variables that could be applied to the brief facts you have given. The information offered here is general in nature and is not a legal opinion nor is it specific tax advice.
The 3 out of 5 rule is a presumption test not a conclusive test. By that I mean, the IRS uses that test as initial finding of lack of profit. However, these are facts and circumstances situations, so if you are really engaged in a trade or business and can prove it, you can probably prevail. There are a lot of decided cases out there on this hobby loss issue and the courts looks to a whole laundry list of factors. It is beyond the scope of this forum to go thru them. It would be in your best interest to talk to an experienced tax attorney or tax accountant about these tests and plan accordingly.
Hope this helps.
Mr. Fromm is licensed to practice law in PA. The response herein is not legal advice and does not create an attorney/ client relationship. The response is in the form of legal education and is intended to provide general information about the matter within the question. Oftentimes the question does not include significant and important facts and timelines that if known could significantly change the reply unsuitable. Mr. Fromm strongly advises the questioner to confer with an attorney in their state in order to ensure proper advice is received.
The presumption is that if you do not make a profit in 3 out of five years, that you are engaged in the business as a hobby. Then your losses are limited to the revenue you generate from the business.
If you cannot meet the 3-out-of-5 year rule (3 years of profits in a 5-year period), you can still prove your profit motive using the following nine factors:
1. You carry on the activity in a businesslike manner,
2. The time and effort you put into the activity indicate you intend to make it profitable,
3. You depend on income from the activity for your livelihood,
4. Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
5. You change your methods of operation in an attempt to improve profitability,
6. You, or your advisors, have the knowledge needed to carry on the activity as a successful business,
7. You were successful in making a profit in similar activities in the past,
8. The activity makes a profit in some years, and how much profit it makes, and
9. You can expect to make a future profit from the appreciation of the assets used in the activity.
This list is found in IRS Publication 535 Business Expenses.
Any individual seeking legal advice for their own situation should retain their own legal counsel as this response provides information that is general in nature and not specific to any person's unique situation. Circular 230 Disclaimer - Advice given in this response cannot be used to eliminate penalties with the IRS or any other governmental agency.