Does Your Business Losses Trigger an IRS Audit? If So, Do This
If you operate what you think is a business, but that business loses money, it may not be a business at all under the tax code.
Such a money-losing activity can look like a tax shelter to the IRS, and that substantially increases your chances of an IRS audit.
The tax code contains a business loss safe harbor that’s known as a presumption of profit. You meet this safe harbor when your activity produces a profit in three of five years (two of seven for breeding, training, showing, or racing horses).
When you meet the safe harbor, you are presumed a business unless the IRS establishes to the contrary.
We know this for-profit tax code section as the hobby loss section. But you can see that this tax code section creates trouble for much more than what you would consider a simple hobby.
Here’s an example of how badly the recent tax reform under the Tax Cuts and Jobs Act can treat a business that loses money.
Example. Henry has an activity that fails the business test and loses money. Last year, he had $70,000 of income and $100,000 of losses. Under pre-tax-reform law, Henry could claim the hobby-related business deductions up to the amount of his income. So Henry deducted $70,000 (subject to some minor adjustments) and reported close to zero taxable income.
Not this year. Tax reform is going to make Henry suffer. With the same facts, Henry’s business deductions are zero. His taxable income is $70,000.
Think about that. Henry lost $30,000 ($70,000 – $100,000) in real money. He now pays taxes on $70,000 of phantom income.
What can Henry do to make this problem go away? He has two choices.
- First, he could create a “for profit” business defense in the hope that he would defeat the IRS in an audit.
- Alternatively, he could stop the taxation on his phantom income by operating his activity as a C corporation.
If you would like to discuss either or both of these possibilities, please call me at (734) 666-5462 and we will set a time when we can get together to cover the possibilities.
These benefits must be weighed against costs to the federal government and to employers. The federal government must borrow for the tax credits that are going to subsidize mandated paid leave. Employers will face a considerable new compliance burden, they will temporarily lose services provided by workers, and they will lose much-needed cash flow that must be diverted to bridge the gap between paid leave payroll and the realization of benefits from tax credits.
The Families First Coronavirus Response Act (H.R. 6201), which the Senate passed and President Trump signed into law March 18, provides exceptions from paid leave requirements to three classes of employers. It puts limits on the amount each employee can receive. It expires at the end of 2020. It has an estimated revenue cost of $105 billion. And it defines what employee characteristics and situations (“qualifying needs”) make an employee eligible for paid leave.
If employer and employee are in the scope of the provisions, paid sick leave can be provided for that employee for up to 10 days. Following that period, paid family leave can be provided for up to 10 more weeks. Paid sick leave can be either 100 percent of regular pay (subject to a $511-per-day cap) or two-thirds of regular pay (subject to a $200-per-day cap). Paid family leave also is two-thirds of regular pay (subject to a $200-per-day cap). The $511 daily cap limits paid leave for employees earning more than $133,000 per year. The $200 daily cap limits paid leave for employees earning more than $78,000 per year.
In general, the more generous sick leave benefit is available for an employee who is ill, symptomatic, or self-isolated. The less generous benefit is available for an employee who cares for others with coronavirus-related issues. The family leave benefit is only available for parents of children out of school or without day care. Those descriptions are way too general. We think interpretation of the statutory language will matter a lot, so we are providing that text in the accompanying box.
Out of Luck
The pie chart shows the composition of the U.S. workforce in 2019. Out of 159 million individuals, 59 million are ineligible for any paid leave under the bill because employers with more than 500 employees are not required to provide paid sick leave. Also under the bill, the labor secretary can exempt employers with fewer than 50 employees from the requirements to provide paid sick leave (but not paid family leave). In the United States, 34 million individuals work for employers with fewer than 50 employees.
Public sector employees (except perhaps healthcare workers and emergency responders) are eligible for all paid leave. But note that their employers, mostly state and local governments, are ineligible for payroll tax credits available to private sector employers. Self-employed individuals (9.5 million) are eligible for income tax credits of equal size to employer payroll credits. It will be extremely difficult for the IRS to prevent abuse in this area. After all, how can a self-employed person prove no work is being done during a period when that person is claiming the income tax credit?
Under the bill, presumably because we don’t want to provide any incentive for healthcare workers and emergency responders to stay home, their employers don’t have to provide them with paid sick and family leave. Exact definitions will matter. But a quick review of Labor Department data suggests that 18 million workers could be adversely affected by this provision.
Based on the statutory language (in the box), the threshold for qualifying for full paid sick leave benefits seems low and nearly impossible for the government to police. If a healthcare professional (who presumably could be a family member) tells you to stay home, or if you sneeze or cough or have a fever and you call for a doctor’s appointment, you may qualify for full sick leave benefits.
The threshold for qualifying for two-thirds benefits also seems low. If you are caring for any individual — a family member, a neighbor, a friend — who needs to be isolated, you qualify. If your own child under 18 is kept out of school, you can qualify. As we write this, mandatory closure of schools nationwide is nearly complete, so it seems tens of millions of working parents can readily qualify. But note that if you have a dependent (for example, a grandchild) who is out of school, you do not qualify.
In contrast, eligibility for extended family leave seems disproportionately narrow. If your perfectly healthy child is out of school, you can get 10 additional weeks of paid family leave after paid sick leave is exhausted. But if you are ill with the coronavirus, say, for two weeks, and then you are taking care of others who are ill in following weeks, you are not entitled to any family leave (after the first two weeks of sick leave is exhausted).
Down and Out
Around the country, applications for unemployment compensation are skyrocketing. Many economists are now predicting the number of U.S. unemployed will increase by millions. This raises thorny legal and policy questions about how those workers will be treated under H.R. 6201.
Speaking generally, sick and family leave benefits seem to be all about the labor supply. What that means is that if a worker has a situation that requires attention at home, that worker can stay home. In other words, reduced labor supply.
In the coronavirus economy, the simultaneous collapse of labor supply (because workers are sick or want to minimize contact) is closely intermingled with the collapse of labor demand (because employers do not have demand for their products, because they are ordered — or it is recommended — that they close their doors, or they cannot get parts from their broken supply chains). From the perspective of an employee enduring hard times, the loss of pay due to a doctor’s order (affecting labor supply) is not very different from the loss of pay due to a temporary business shutdown (affecting the demand for labor). But examining the statutory language of the bill, there does seem to be a big difference.
If, as seems likely, this bill becomes law shortly, we all will need to be asking and answering important questions like these:
· If an employer voluntarily temporarily shuts down business because of concerns about the health of employees and customers, does an employee of that business qualify for paid leave?
· If an employer voluntarily temporarily shuts down business because business is slow (because of the coronavirus), does an employee of that business qualify for paid leave?
· If an employer is ordered to close or scale down business by a government official, does an employee of that business qualify for paid leave?
If, as we suspect (based on the statutory language), the answer to these questions is no, we can only ask, why not?
Coronavirus-Related Conditions That Qualify for Paid Leave
Under H.R. 6201, sick leave is available if:
1. The employee is subject to a federal, state, or local quarantine or isolation order related to COVID-19.
2. The employee has been advised by a healthcare provider to self-quarantine because of concerns related to COVID-19.
3. The employee is experiencing symptoms of COVID-19 and seeking a medical diagnosis.
4. The employee is caring for an individual who is subject to an order as described in (1) or has been advised as described in (2).
5. The employee is caring for a child of such employee if the school or place of care of the child has been closed, or the child care provider of such child is unavailable, because of COVID-19 precautions.
6. The employee is experiencing any other substantially similar condition specified by the secretary of health and human services in consultation with the Treasury secretary and the labor secretary.
Relationship To Paid Leave.—
“(1) UNPAID LEAVE FOR INITIAL 10 DAYS.—
“(A) IN GENERAL. —The first 10 days for which an employee takes leave under section 102(a)(1)(F) may consist of unpaid leave.“(B) EMPLOYEE ELECTION. —An employee may elect to substitute any accrued vacation leave, personal leave, or medical or sick leave for unpaid leave under section 102(a)(1)(F) in accordance with section 102(d)(2)(B).
Full sick pay (limited to $511 per day) is available for an employee in categories (1) through (3). Two-thirds of sick pay is available for employees in categories (4) through (6).
Family leave is available only for an employee who “is unable to work (or telework) due to a need for leave to care for the son or daughter under 18 years of age of such employee if the school or place of care has been closed, or the child care provider of such son or daughter is unavailable, due to a public health emergency” related to COVID-19.
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