Small Business Taxes & Management^TM--Copyright 2010, A/N Group, Inc.

Introduction

It's not unusual for entrepreneurs to have multiple businesses. In fact, it's quite common. For example, Fred Flood conducts business as a sole proprietorship and files a Schedule C for the used car lot he's been operating for the past five years in New Jersey. He opens an auto repair shop (as a sole proprietorship) near his vacation home in southern Vermont. The used car lot is consistently profitable, but the repair shop doesn't turn a profit so he reports the two operations as one on his Schedule C, offsetting the income and losses.

The IRS may not accept this approach. There's a good chance the IRS will view the operations as two separate activities and subject each to the not-for-profit activity (hobby loss) rules of Section 183. Whether or not the IRS will challenge the offset will depend on the facts and circumstances. The IRS and the courts can examine a number of factors and weigh them to determine whether the taxpayer is operating a single or multiple activities.

Issues

In the example above, the geographic separation of the two operations may indicate that they are two separate activities. The case against the two operations being integrated grows because the two operations serve no joint business purpose. The fact that the repair shop is operated by a manager, while Fred oversees only the used car lot will make it worse. While both activities involve autos, they are unlikely to be integrated.

On the other hand, Fred might be able to convince the IRS (or a court) that the two operations are integrated if Fred manages both businesses, if the books and records are kept using a common system, if the repair shop regularly does significant repairs on autos sold by the used car lot (particularly if Fred can show cost savings by using the Vermont shop).

Will the IRS challenge every multiple activity where a loss is offset by a profit? That's highly unlikely. There are really three situations where a taxpayer should be concerned. The first involves hobby losses where a taxpayer reports the operations of an unrelated business that consistently incurs losses with a profitable operation. For example, Fred has a profitable auto repair business with three close locations. He and his wife also breed and show pedigree dogs. That operation loses money. In an effort to deduct the losses without arousing the IRS, Fred reports it on the same Schedule C with the losses offsetting the repair shops.

The second involves a start-up operation. Expenses incurred in expanding an ongoing business are generally currently deductible. But expenses incurred in starting a new business must generally be capitalized and amortized over 15 years (there is a special exception; the first $5,000 of expenses may be deducted if the total start-up expenses don't exceed $50,000). Whether by accident or design, a taxpayer can get a significant writeoff if he or she claims the new operation is really an extension of the original business.

For example, Fred operates a foreign auto parts retail and online store. The operation is profitable and he decides to build a garage at the same location that specializes in foreign auto repairs. Fred's startup expenses amount to $70,000 and include the cost of hiring mechanics and other help, setting up bookkeeping and an operations manual, and advertising and promoting the operation. If this were an integrated operation, Fred could deduct the startup costs immediately. If not, they must be capitalized and amortized.

The last situation involves the material participation rules. That's a broader issue and involves profitable and unprofitable operations and whether or not a taxpayer can deduct losses of a operation (sole proprietorship, S corporation, LLC, partnership). While the rules are more involved, the concept is similar. We won't get into that issue here.

Factors IRS Examines

What factors do the IRS and the courts look at to determine if the activities are integrated? Here's the list:

• Degree of organizational and economic interrelationship of the undertakings.
  
• Business purpose served by carrying on the undertakings separately or together.
  
• Similarity of the undertakings.
  
• Whether undertakings are conducted at the same place.
  
• Whether the undertakings were part of the taxpayer's efforts to find sources of revenue from his or her land.
  
• Whether the undertakings benefited from the other.
  
• Whether the taxpayer used one undertaking to advertise the other.
  
• The degree to which one caretaker oversaw the assets of both undertakings.
  
• Whether the taxpayer used the same accountant for the undertakings.
  
• The degree to which the undertakings shared books and records.

Fortunately, the IRS generally accepts the taxpayer's characterization of two or more undertakings as one activity unless the characterization is artificial or unreasonable.

There have been a number of Tax Court cases on this issue. In one the IRS asserted that tree planting, timber harvesting, and haying were separate activities. The IRS did not convince the court and the taxpayer won.

But that doesn't mean you shouldn't be prepared. In many cases there's nothing you can do. It's pretty much impossible to convince the IRS your dental practice and your tropical fish breeding are integrated. But it would be a shame to get challenged on similar activities or activities that support each other by not setting the facts up in your favor.

Whether or not the activities are separate, you should have a way of allocating costs among them. For example, you have a tractor you use for custom mowing but also use on your farm. In arriving at the net income from the operations, you should be able to allocate the costs on some reasonable basis. In this case, operating hours probably makes the most sense.

As always, if you sense an issue, talk to your accountant or tax adviser. And make sure he has all the facts.

References:

IRC Sec. 183
IRC Sec. 195
Reg. Sec. 1.183-1(d)(1)
Mitchell, T.C. Memo. 2006-145
Keanini, 94 T.C. 41, 46
Tobin, T.C. Memo. 1999-328
Estate of Brockenbrough, T.C. Memo. 1998-454
Hoyle, T.C. Memo. 1994-592
De Mendoza, T.C. Memo. 1994-314
Scheidt, T.C. Memo. 1992-9

--Last Update 07/07/10