The IRS uses “9 Factors” to help it determine whether a business is being carried on with a profit motive. Please read the information below, which is from the IRS audit manual, to see what kind of record keeping should be done. Most small businesses fall far short in this category.
(1) Manner in which the taxpayer carries on the activity. – The fact that the taxpayer carries on the activity in a businesslike manner and maintains complete and accurate books and records may indicate that the activity is engaged in for profit. Similarly, where an activity is carried on in a manner substantially similar to other activities of the same nature which are profitable, a profit motive may be indicated. A change of operating methods, adoption of new techniques or abandonment of unprofitable methods in a manner consistent with an intent to improve profitability may also indicate a profit motive.
The examiner needs to inquire about the books and records maintained for the activity during the Initial Interview. The examiner should document in the workpapers regarding the sophistication of the taxpayer’s books and records. The examiner should determine if the taxpayer maintains checking accounts for the activity which are separate from the accounts used for the taxpayer’s personal living expenses.
Depending upon the volume, the examiner should obtain photocopies of the taxpayer’s entire set of books and records. If photocopying the entire set of books and records proves to be cost prohibitive, the examiner should only photocopy samples representative of the overall books and records.
The presence of sophisticated books and records does not automatically equate to profit motive. The taxpayer must be relying upon these records in order to operate the activity and make decisions or changes. The examiner needs to document how these records are utilized by the taxpayer.
The taxpayer should have a formal written Business Plan. This plan should demonstrate the taxpayer’s financial and economic forecast for the activity. The plan should not be a “fantasy profit and loss statement.” In other words, some taxpayers may wish to submit a business plan that is nothing more than a Schedule F or C, which unrealistically overstates the gross receipts and unrealistically understates the expenses for the activity.
The examiner should not request the business plan in the first IDR. Otherwise, the examiner will possibly receive a “canned” document. The examiner should inquire as to the business plan during the Initial Interview and follow-up with a subsequent appointment and/or IDR.
A business plan should show a short range and long range forecast for the activity. The forecast should allow for changes due to potential unforeseen and fortuitous circumstances.
The plan should be realistic. The examiner should perform quantitative analyses in order to determine the reasonableness of the projected gross receipts and various expense items. The examiner may consult with IRS economists in order to review the business plan.
The examiner should determine if the taxpayer followed the plan and if the original plan was not successful did the taxpayer made any amendments to the plan to increase profitability.
The examiner needs to document the taxpayer’s method of operation. The examiner should document the daily operation as well as the history of the activity’s operation in the workpapers. Denote changes in the method of operation over the years and indicate why these changes were initiated. Most of this information will be gathered during the Initial Interview.
The examiner needs to document the efficiency of the taxpayer’s operation. Denote the taxpayer’s use of any experts or specialists. Indicate if any changes were initiated and why. Obtain names, position titles, and addresses. Most of this information will be gathered during the Initial Interview.
The examiner will note whether the taxpayer is making changes to the operation that will result in improved operational efficiency.
The examiner needs to review the actual copy of any advertising in instances where the taxpayer has deducted such expenditures. Many taxpayers will buy advertising space for “vanity” ads. These spaces are sometimes purchased to place photographs of their children. These ads may wish the children “Best of luck” prior to upcoming competitions. The examiner should use professional judgment to determine whether the advertisements truly represent promotion of the taxpayer’s activity.
The examiner needs to be alert for the children’s activities being deducted on the parents’ tax return. The examiner needs to review reports and determine who actually competes in certain activities. The parents may contend that the children are promoting the activity through the competitions. The examiner needs to consider the substance of the facts.
Depreciation and Inventory can be viable issues for the examiner to consider as an aside from IRC § 183. The examiner should develop a clear understanding
of the taxpayer’s activity and verify that the proper tax treatment is used for the activity.
Summary of Factor 1
The examiner must document the manner in which the taxpayer carries on the activity. Most of this information will be gathered during the Initial Interview and the tour of the operation. It is important for the examiner to document a clear understanding of the activity. Assumptions should not be made that each activity operates the same as another similar activity.
