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I frequently advise published and unpublished writers on the tax aspects of their writing business and this is definitely one type of business where it can take years to generate income. It is also a business that is subject to a large amount of rejection and can take a significant amount of time to create a salable product. As with budding musicians and thespians, it's also an environment where the market is unpredictable.
So, how does the IRS know you have or have not generated income? By evaluating line 1 - Gross Receipts - of the Schedule C. This is exemplified in the U.S. Tax Court case of N. Joseph Calarco, a professor and playwright who was audited by the IRS after five years of zero income and expenses in excess of twenty thousand dollars for each year. The IRS position to the court was that the lack of income was an indication of no intent to make a profit and contended that Professor Calarco's business was really a hobby and subject to the hobby rules and limitations which are not as favorable as the small business rules and allowances.
The U.S. Tax Court evaluated several things but of primary importance was the issue of intent to make a profit. Professor Calarco was found by the court to have intended to make a profit but that in his business environment that this was difficult to do. However, certain expenses were disallowed and viewed as excessive by the U.S. Tax Court. Professor Calarco's victory concerning the intent to make a profit was crucial both in terms of money and the future of his business. To read the complete U.S. Tax Court report on this case go to www.legalbitstream.com and search on N. Joseph Calarco.
What's important here is that the IRS super computers can indeed assess when any business is making a profit or not and this can be compared and assessed over time. Moreover, not having any business income at all, especially with high expenses will get the small business owner noticed by the IRS, but the truth is that just by filing a Schedule C this is likely to happen. So, the small business owner has to be prepared for an audit no matter what, especially today in a climate where all government agencies are looking to collect more revenue without officially raising taxes.
One of the worst things a small business owner can do is fudge' income and/or expenses in any direction. Small Business owners frequently ask me if they should just forgo expenses in later years to show that they've made a profit in the false belief that this will keep the IRS from auditing them. This is actually a good way to keep the attention of the IRS squarely on the small business for long periods of time and perhaps even get attention from the Department of Justice. This is because it's illegal to intentionally misrepresent any information on a income tax return.
There are a myriad of income tax credits that are affected by what is called the Adjusted Gross Income (AGI) of every individual U.S. income tax payer. Some credits require less income to qualify and some require more and since the Schedule C (Sole Proprietor) business gains or losses are part of the individual's income tax return, misreporting income in either direction could qualify these taxpayers for credits they would otherwise not receive.
Accurate income and expense record keeping is critical in an audit. Once a small business owner is found to have intentionally misreported anything on their business return that business will then be monitored. Every small business owner should be truthful and honestly intend to make a profit and keep accurate business records that realistically reflect business income and expenses within the confines of the tax code.