Accounting Articles > IRS Audit:
An IRS audit on a business’ losses
If you are being audited on a business that produces consistent loses, you might be asking “Why would the IRS do such a silly thing?”
The question, from a taxation standpoint, is whether your enterprise is a business or a hobby. If your enterprise is a hobby, then your losses may not deductible.
The standard rule is that if a business shows losses in three of five consecutive years, then it can be considered a hobby. But there are mitigating factors that can determine that your activity is “for profit,” rather than a hobby:
- Are the losses due to circumstances beyond the taxpayer’s control?
- Is a future profit expected to be made from the appreciation of assets?
- Has profit been made in similar activities in the past?
If your activity is determined to be a hobby, then your losses are subject to the 2% miscellaneous deduction floor of Schedule A of Form 1040, the personal income tax return.
Another reason your unprofitable company might be audited would take into account your S-Status. If you have an S-Corp and you are showing losses, then those losses will flow through to your personal return. If you have a basis for the deductibility of the loss, then the losses can be deducted against regular income and you will pay less income tax.
If you are paying less income tax because of a business loss, they might audit you to make sure that the losses are reasonable.
Of course if the return was done wrong, with several areas being red-flagged by the IRS diagnostic system, you will probably be audited regardless of any income or loss.
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