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What to Know About the IRS's Safe Harbor Clause

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In the latest installment of his series addressing the tax concerns of freelancers, Julian Block discusses Section 183 of the tax code, which contains a carefully worded safe-harbor clause for small business owners. It's one of a few ways the IRS differentiates between business income and hobbies.

Aug 19th 2021
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Just joining in? Go back to parts one and two, where I answered unusual questions submitted by Waldo Lydecker, a freelancer who said he’ll pocket a seven-figure advance noticeably north of one million dollars for his next book and who was adamant that he’s entitled to my advice on how to trim his tax tab.

Part three discussed Internal Revenue Code Section 183, which allows “business” losses and prohibits “hobby” losses. Our lawmakers made sure to include a precisely worded safe harbor within Section 183. 

Safe harbor. Section 183 presumes that freelance writer Ceil engages in a business, as opposed to a hobby, provided she has a net profit, meaning, in IRS lingo, an excess of receipts over expenses in any three out of the last five consecutive years. Note, though, that it allows the agency to rebut that presumption.  

(By the way, Congress, in its wisdom, decided that writers, photographers, artists and the like aren’t as deserving as individuals involved in the breeding, showing or racing of horses. A precisely worded exception confers an easier standard on them. They only have to show net profits in two out of seven years.) 

Consequently, Ceil usually doesn’t have to fret if she has at least three profitable years during the last four. Satisfying that stipulation entitles her to fully deduct her expenses this year. It’s okay even if this year’s 1040 form reports a loss. 

Suppose she submits 1040s that report losses in more than two out of five years. It’s not fatal. The IRS permits Ceil to establish that she conducts a “for-profit” business, provided she passes its “facts and circumstances” test. 

What follows are some of the factors that IRS auditors reflect on when they grade her test. In my experience, the auditors are reasonable. They never consider one factor to be conclusive; one person’s hobby can turn out to be another person’s business.

For starters, IRS graders never require Ceil to be the smartest person in the room, though, understandably, they’ll want to know if she knows what she’s doing, or, if not, relies on knowledgeable advisers. 

Another likely question: How much time and effort does Ceil expend in the conduct of her career as a writer? The burden of proof to establish that is on Ceil, not the IRS.

Does she keep accurate and thorough records? To placate graders, she should save records of her payments for things like supplies and equipment. Ditto for queries to publishers and programs from writers’ conferences. 

Something else they’ll ask: Is she really trying to make money as, say, a writer or photographer? 

It all depends. For instance, IRS examiners figured out long ago that freelancers who submit articles or photos to publications that pay only in copies usually are hobbyists. 

But they also acknowledge that it’s possible for Ceil to qualify as a professional writer, even when she’s employed full-time in some other field––as is the case with many freelancers. They concede that she can earn a paycheck elsewhere and nonetheless have a legitimate freelance-writing business.

How successful has Ceil been in carrying on other business endeavors? What’s her history of income or losses from her writing or other undertakings? What amounts of occasional profits, if any, did she earn?

Are losses common in the start-up phase of a freelancer’s type of business? In particular, test graders focus on whether she has suffered a string of losses. 

Consequently, Ceil should prepare herself to show skeptical examiners why it made sense for her to endure unbroken financial losses while she endeavored to replace a struggling business with a successful operation.

Stay tuned for part five. It answers more questions from freelance writers.

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By thebreezybookkeeper
Aug 23rd 2021 06:25

Greetings,

Thank you for sharing your blog.

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