THE CRAFTS REPORT
THE OPPORTUNITIES
AND PERILS OF BUSINESS LOSSES
We don’t really like to talk about it, but craft businesses can lose money at different stages. It is quite common for start-up ventures to show a loss for the first year or so. If these emerging businesses prepared a business plan, it would become quite obvious that there may be periods of loss before the business stabilizes in a profitable situation. Usually, though, crafters more often "find" themselves in business. They often begin creating their crafts after learning the skills in a class or while they are students in an art school. They are enthused with the creative process and begin purchasing materials and tools needed to get started. Often, the thought of having a business is the last thing on their mind! Then it turns out that their work is admired by friends and they discover there is quite a demand for their unique creations. Sometime after that, they may start thinking about starting a business.
As tax accountant, I view this scenario as one filled with tax-saving opportunities and also presenting some perils for the unaware. The tax-saving comes with recognizing that there is a business activity going on, reporting it as such, showing the loss and reaping the tax-shelter benefit of the loss The keys to maximizing this benefit are figuring out when the business actually has begun and keeping accurate records of all the income and expenditures.
A business begins on the day it is first "open for business". This could be as soon as you have anything saleable produced and you let someone know it is available for sale. It doesn’t have to wait until you go to your first show, or open a store, or even pay for advertising. The earlier you can identify this date, the sooner you can start deducting expenses. Note that expenses paid for before this start date can still be used. They are called "start-up expenses" and are deductible ratably (amortized) over the first 60 months of the business. Business expenses other than inventory items are deductible in each year as they are paid for once the business is open. It is important to get help in setting up a recordkeeping system that will efficiently and accurately capture each and every business expense.
In any tax year, if the bottom line of your Schedule C shows a loss because there were more expenses than income, you are allowed to benefit from that loss by having it offset any other income in your tax return. This will reduce the tax and could produce a refund to help ease the cash flow of the beginning business venture. If you don’t show much other income in the same tax return, the business loss may be significant enough to qualify as a "Net Operating Loss" or NOL. If your Adjusted Gross Income at the bottom of the first page of your Form 1040 is negative, you should get a copy of Form 1045 which has a worksheet for calculating the NOL. If you have a NOL, you haven’t had the tax benefit of your loss yet, because there wasn’t enough other income to offset. The tax law, therefore, allows you to carry the loss back to the third prior year to offset income that was taxed in that year. If the NOL isn’t all used up in that year, it can be carried forward to the second and first prior years and on forward for up to 15 years until you have received the full benefit of the loss. Filing Form 1045 will be your claim for a refund of taxes paid in prior years.
It is important to do this calculation BEFORE you send in your tax return with the NOL. This is because you may realize it will not be best for you to carry the loss back three years. You have the option of electing to forego the three-year carryback and just carry the loss forward. However, you MUST attach an election statement to your originally filed return in order to have the right to go forward only. This is a situation that is often missed by taxpayers preparing their own returns, and it is even missed by many professional tax return preparers. So, it’s up to you to be savvy to the opportunity!
If losses continue for more than two years, you need to determine whether or not you have a serious intention and expectation of someday being able to make a profit. If you do, you will want to start documenting all your efforts. This is because IRS could challenge your right to deduct your losses if they think you aren’t trying to make a profit. After two years of losses, the burden of proving your profit motive rests on your own shoulders. You don’t have to stop claiming your losses voluntarily if you do have an expectation of making a profit. Likewise, IRS can’t just come along and disallow your losses without giving you a chance to prove your efforts and potential. They will allow the losses if you can show you are taking the business seriously (and not having too much fun!), looking to experts for help in becoming profitable, keeping accurate business records, promoting and improving your business, and especially if you are relying on the income from the business.
On the other hand, you may discover, as did a client of mine, that you may never make a profit. You may just love doing what you are doing...in comparison to your "real job" perhaps. You may feel you could never charge enough for each creation to really make it "worth while", but you’re not willing to give it up. This situation would actually be called a hobby or a not-for-profit activity and I feel it is very important to dispel any shame one might feel about being in this situation. IRS isn’t going to put you in jail and The Crafts Report will still allow you to subscribe and you can still go to shows! However, you should, after the first two years of losses, voluntarily limit your expense deductions to exactly the amount of your income. Do this is by reporting on Schedule C all of the expenses. Then on the "other expense" line, enter a "negative deduction" equal to the amount of your loss causing the bottom line to equal zero.
Just as important is for you to still treat your work as a business and keep track of all your expenses. This will enable you to manage the amount of your personal finances that are being invested in your creative activity. You want to keep your eyes open and be honest with yourself about how much money it is costing. I have seen such situations spiral into major credit problems quite quickly. You can avoid that and still enjoy your work by paying attention and even deciding each year how much you are willing to spend on your business/hobby. Then you can just enjoy doing what you love!
For more detailed information:
Look in the following IRS Publications under the headings
"Net Operating Losses" and "Not-for-Profit Activities":
Publication 334 - Tax Guide for Small Business
Publication 535 - Business Expenses
Publication 536 - Net Operating Losses
Form 1045 - Application for Tentative Refund
