GringoPost | Ecuador: Business "For Profit" vs "Hobby Loss Rules"

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Business "For Profit" vs "Hobby Loss Rules"

For those US citizens that operate a business in Cuenca, a couple of rules will apply to you. First, is the requirement that you report your world-wide income no matter the source (Title 26 U.S.C). Second has to do with the deductibility of a "loss". The prima facia fact, or on the surface, would indicate that any business is conducted with a "for profit" motive. Not so, says the I.R.S. You have to prove that you are conducting the business for profit. They utilize "objective" over "subjective" factors to decide that a loss can be used to offset other income, so the burden of proof is on your shoulders.

Under normal circumstances, your business related expenses are fully deductible under Code Sections 162, or 212 and any loss over income would be listed on Form 1040 Line 12 which is your business Schedule C. The I.R.S. guidelines also indicate that you need to show a profit in 3 out of 5 tax years.

So how does the Service determine whether an activity is engaged in for profit. (1) Manner in which the taxpayer carried out the activity: did you treat it like a business (2) Expertise of the taxpayer: do you understand the economics of the activity (3) Time and effort expended on the activity: did you devote a substantial amount of your time (4) Success of the taxpayer in carrying on similar activities: have you done this before (5) Taxpayer's history of income or loss with respect to the activity: after the "start-up" period are you beginning to show a profit (6) Amount of occasional profits: were the profits substantial or minimal. See Code Section 183.

If you've just begun your business activity and the possibility of a loss is probable, you can file Form 5213 "Election To Postpone Determination As To Whether The Presumption Applies That An Activity Is Engaged In For Profit" during your first year of business and applies to the first five years of operation. The benefit of making this election is that the Service will not immediately question your motive. However, if the activity fails to show the requisite profit under the 3 out of 5 year test, deduction limits will be applied retroactively to any year within the 5 year period. See Treasury Reg. Code Section 1.183-2(b).

So, how bad can it be if the Service hits you with the "hobby loss rules". For starters, you will not be allowed the use of Schedule C. Instead you are required to report your GROSS receipts on Form 1040, Line 21 Other Income. Your expenses, with an exception, will flow to Schedule A Miscellaneous Deductions after the 2% limitation is applied. Bottom line, you will probably get NO write-off benefit from the expenses if you cannot itemize.

What if you don't agree with the Service's findings. You can go to "Appeals" or take your case to the Taxpayer Advocates Office. If that fails, your only other choice is to hire a Tax Attorney, about $600 per hour, and take your case through the Tax, District or Appellate Courts.

Whether an activity is engaged in a "for profit" is a question of fact. The requisite profit objective will be determined from all the facts and circumstances. Courts have found in favor of the taxpayer even where the activity has shown losses from 1991 through 2009 (Metz vs Commissioner).

So, in closing I cannot stress the importance of maintaining adequate WRITTEN records that will properly reflect income and expenses in the endeavor of your choice.

One other thing. In my last post dealing with crypto-currencies, one of the posts alluded to "revoke your election". I can only draw the conclusion that it is a referral to Revocation of U.S. Citizenship. Even if you do this, all the tax years before revocation subjected you to all of its laws. As to the other comment regarding "washing" your coins. I have no idea what that refers to, but to me smacks squarely of "tax fraud" and I would never recommend you do such a thing. Nothing in the codes allows you to "ignore" buying, selling, trading, paying or being paid in any of the crypto-currencies. They all qualify as tax events. If you follow such advice, I'll be sure to visit you at Leavenworth next time I visit Kansas.

As always, if you have questions please feel free to email me.

February 1, 2018, Cuenca

John Papile: