Being a small business owner brings with it a host of challenges. You are not only concerned with meeting the needs of your client, charging and paying your suppliers. You also have to worry about complying with federal and state laws, as well as local guidelines. Small business owners, especially sole proprietors, are at greater audit risk. The federal government believes that the self-employed are grossly underreporting their income and overstating their expenses. According to the Tax Help Online website, “You may be surprised to learn that 20% of all small business audits involve the cancellation of deductions because the IRS reclassifies small business as a hobby under the so-called ‘loss of income’ rule.” hobby'”. Section 183 of the Internal Revenue Code (Activities Not Conducted for Profit) limits the deductions that can be claimed when an activity is conducted not for profit. IRC 183 is sometimes called the “hobby loss rule”. As a small business owner, it is your responsibility to ensure that your business is seen as a legitimate business in the eyes of the IRS and not a hobby.

Below I’ve listed some smart business practices that will not only help you define and grow your business, but also help document that you’re running a real business and not just pursuing a hobby.

1) Write a business plan. There are many local small business support centers that can help you put your plan in writing. For example, the Small Business Administration has local and online resources to help you.

2) Determine your legal structure (LLC, Partnership, C Corporation, S Corporation, Sole Proprietorship).

3) Obtain an Employee Identification Number (EIN) from the IRS.

4) Open a separate bank account for all your business transactions (deposits and expenses). You must keep your personal and business transactions separate.

5) Establish a separate line of credit or credit card to use with your business. Put personal expenses on a personal card and put business expenses on a business card.

6) Keep your business documents organized. The National Federation of Independent Business recommends keeping business records and receipts for at least seven years.

7) File complete tax returns on time. This would include all required attachments and signatures. Depending on the type of organization you have, you or your CPA will complete forms such as 1020, 1065, 1040 Schedule C, 1096, 1099, 940 along with your self-employment tax calculation. I recommend finding a local Certified Public Accountant (CPA) who is familiar with your industry to help you determine which forms you will need to file and ensure they are submitted on time and to the correct government office.

8) Hire a support team: A lawyer can help you with your legal structure and a Certified Public Accountant can help you keep your finances in order and comply with local, state and federal government.

9) Create industry standard business documents and forms including: logo, letterhead, business cards and website.

10) Advertise in the local media along with the corresponding trade publications.

According to the IRS document, FS-2008-23, below are some of the questions the IRS may ask when determining if your business is engaged in a for-profit activity. You will need to be prepared to answer these questions and provide documentation.

1) How many hours a week do you work in the business?

2) Do you depend on the income from this activity to pay your bills?

3) Do you have the necessary knowledge to carry out the activity as a successful business?

4) Have you made a profit in similar activities in the past?

5) Does the activity generate profits in some years?

6) Do you expect the activity to generate profits in the future?

7) Are there elements of personal pleasure or recreation?

8) Has your business made a profit in 3 of the last 5 years?

According to IRC 183, “If your business activity is not conducted for profit, the allowable deductions cannot exceed the gross receipts from the activity.” The result is that your business deductions will now become itemized deductions and will be limited to income from your hobby.

For more information and assistance to help your company maintain its position as a legitimate business, contact a local CPA. Each state has its own independent licensing board. If you are in North Carolina, you can contact the NC CPA Board website and click the “Licensee Search” button to locate a CPA near you. All licensed and active CPAs in North Carolina will be found on this website.