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IRS Three-out-of-five-year Profit Rule - Fact or Myth?

For decades the word has spread that if a small business, primarily in the form of a Schedule C (Sole Proprietorship), doesn't show a profit in three out of five years then the IRS will automatically audit that business and subject it to all kinds of financial punishments.

The question - is this true, or is this a myth? The answer - it's mostly a myth with an element of truth. The reason - it's often misinterpreted and taken out of context.

In all the years I worked as a senior tax advisor, at least once every tax season I would be confronted with a client's fears that this was the year the IRS was going to "get them" over the three-out-of-five-years profit rule. In response I would calmly review the information contained in the following IRS materials, which can be found at www.irs.gov:

Schedule C Form
Schedule C Form Instructions
Publication 334, Tax Guide for Small Businesses (Schedule C)
Publication 535, Business Expenses

The essence of this information is as follows:

- Did the business owner materially participate in the business?
- Did the business owner intend to make a profit whether or not one was realized?
- If a profit was not realized over time, did the business owner take the necessary steps in running the business to improve the potential for making a profit?
- Were the expenses related to the business reasonable and necessary for the type of business being operated?
- Do the business income and expense records accurately reflect all of the above?

A detailed review of the IRS Schedule C, Schedule C Instructions and the publications referenced above will help the business owner understand each of these elements that are necessary to maintain an intent-to-make-a-profit status with the IRS. It is this intent to make a profit that is one of the most critical elements of negotiating a successful IRS and potentially state revenue audit of a small business.

Now there's a difference between not making a profit and having zero dollars worth of income, and it's the lack of generating income over time that the IRS is most interested in because if income isn't being generated then the IRS assumes that the intent to make a profit doesn't exist. This is true to a certain extent but it really depends on the type of business in operation.

I frequently advise published and unpublished writers on the tax aspects of their writing business and this is definitely one type of business where it can take years to

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