You must have a profit in 3 out of 5 years: Hogwash!!

June WalkerDear June —

How many years are you allowed to list a negative profit and still deduct expenses like CS3, or art materials and marketing as you get started…It’s tough to get “on the ticket” and get to be a resource that art directors call on for work and then give you the job. Thanks,
Elizabeth

Hello Elizabeth,

There’s an urban myth been circulating for a long time that an indie must make a profit in three out of five years in order to be considered a business.

Hogwash! Sloppy thinking. A logical fallacy.

The IRS reg says that you are a business if you make a profit in three out of five years. It does not say that you are not a business if you don’t make a profit in three out of five years.

Here’s some excerpts from my blog posts to help explain:

The goal of a business is to make money. As long as making a profit is your goal you don’t have to actually make money. You may also enjoy yourself, help others, or master skills or develop a nascent talent. You may deduct all legitimate business expenses regardless the amount of income. (From Exotic Dancer and more …)

There is no rule about a time limit on losing money. Never was a rule — an old husbands’ tale, maybe. For a better understanding, think of it in reverse: If your business makes a profit in three out of five years, you’re home free. You are a business. Notice that says that if you make a profit, not that you must make a profit. As long as your goal is to make money, you’re OK.

The IRS says that in order for you to be engaged in a business rather than a hobby, the goal must be to make a profit. The IRS doesn’t insist that you actually make a profit, but there must be a reasonable expectation of one.

How do you prove you’re in it to make money if you’re not making any money? That’s too long to go into here but the full explanation is in my book, Self-employed Tax Solutions — with Cheech and Chong as the solo entrepreneur example.

And read this in its entirety HOBBY OR BUSINESS: Are you a professional artist?

Any other questions?

BTW: June Walker’s presentation at CFC 2009 goes into much more detail about these issues and more. Listen to a clip here.