Small Business Taxes & ManagementTM--Copyright 2007, A/N Group, Inc.
You can deduct expenses that are business related and ordinary and necessary. But what happens when the business is dormant? In one case the taxpayer spent over 25 years as a boat worker/repairer. During that time he purchased a substantial number of hand and power tools for use in his boat repair activity. Because of injuries he sustained, he was unable to work in this line and he put his tools in storage. Four years after he stopped working in the marine field he earned an associates degree and a certificate in real estate. He received a real estate salesman's license and then a paralegal certificate. About a year later he began working as a paralegal. Additional injuries prevented him from working in two subsequent years. In some five years after stopped working in the marine business he claimed a deduction of $1,900 for storage of his tools. The deduction was taken on a Schedule C. All other deductions on that single Schedule C related to his paralegal activities.
The IRS disallowed the deduction for storage of the boat repair tools, claiming he was no longer engaged in that business. The Court noted that even an unemployed taxpayer may be considered to be carrying on a trade or business if the taxpayer was previously involved in and intended to return to a particular trade or business. In order to take advantage of what is described as the 'hiatus principle' a taxpayer must show that during the hiatus he intended to resume the same trade or business. In one case (Haft, 40 T.C. 2, 6) the taxpayer was able to show that he hadn't abandoned the business. For a two-year period he had no merchandise to sell. But he maintained contact with his customers and clearly intended to resume the business.
In the case of the marine repair professional the taxpayer was not able to show that. As the years passed it became less likely he would ever return to the marine business or that his services would be in demand. And there was no indication that he maintained contact with his customers. Moreover, the fact that he received a real estate salesman's license and paralegal certificate coupled with physical injuries would have made an argument that he intended to return to the boat business difficult to show.
The Court also took issue with the fact that he combined both the boat repair business and his paralegal activities on one Schedule C. It noted that they were separate and distinct activities and the income and expenses of the two activities should be treated separately.
While the only expense disallowed here was $1,900 for the storage of tools, many other taxpayers might have much higher expenses related to dormant businesses. You could be denied deductions for depreciation, rent, as well as a host of expenses particular to the activity.
What's the best course of action? Fortunately, the tax and business answers are pretty much the same here. First decide whether you want to stay in the business. Are you shutting down the operation because of temporary problems (e.g., economic factors, shortage of raw material, etc.), or is it likely the problems will continue? Getting a depreciation deduction for idle equipment still isn't as good as selling the equipment and putting the cash to a profitable use.
If you think the business will recover, you should take steps to protect your deductions. You can keep in touch with customers at a lower level. For example, reduce your yellow book ad to a minimum, but don't withdraw it completely. You don't have to spend much money on keeping the business active, but you must be able to present a set of facts indicating that you're sincerely looking for business. That could include doing research on ways to reduce costs and/or increase sales, change or enhance product lines, etc. Clearly, the longer shutdown continues, the more difficult your argument that you are still in business.
Consult with your accountant. For two reasons. First, he should be able to provide you with some good advice. Second, the mere fact that you consulted him in an effort to get the business going indicates your intention not to abandon it.
What about rental properties? For example, you own a house you've rented on a continuous basis for several years. Because of severe damage by tenants you've stopped renting and begun rehabbing. For a variety of reasons the project drags on. Can you still list the property as a rental? There's no firm rule here. Of course, the longer you go without income, the more suspicious the IRS will be. You'll be on better ground if you have other properties you rent. It'll probably also help if you keep in touch with real estate agents or other parties who have found tenants for you in the past. Clearly, the quicker you can put the property back on the rental market, the better off you'll be.
Doing nothing could be the worst mistake. For both tax and business reasons. Even if you have no revenue or employees, some expenses will continue. Cut your losses or try to turn the business around.
Copyright 2007 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
--Last Update 09/24/07