Recent conversations with prospective clients:
Prospect: I started a side business doing “XYZ” (one time it was raising shrimp — in Iowa! — while other times it’s been things such as collecting old coins) and I’m hoping I can get all the tax writeoffs for it. I made no money and spent about $10,000. Can I deduct that?
Me: Did you run it as a business? Were you trying to turn a profit? If so, then you probably could write off the loss. But this sounds an awful lot like a hobby, and if that’s the case you wouldn’t be able to write off the loss.
Prospect: (blank stare, often followed by some comment about how their neighbor or their brother-in-law wrote off a huge loss from THEIR Iowa-based shrimp operation. Then the prospect leaves and I don’t hear from them again.)
Prospect: I live on an acreage and have a few goats. I sold one goat for $300 and spent about $8,000 on supplies and feed and other things for the goats. I’m hoping I can deduct that this year and going forward.
Me: Looking at your tax return, you and your spouse make a combined income of $100,000 working full-time jobs in the city. Are your goats really a business?
Prospect: I don’t know, I just want to take advantage of tax writeoffs like everyone else does.
Me: Are you trying to turn a profit? Do you have a business plan? It’s not a huge deal to show a $7,700 loss in year one if there will be profits in future years. But with something like “raising a couple of goats,” it would be hard to argue this is a real business.
Prospect: (blank stare, followed by a comment about how their brother-in-law always writes off huge losses from the three chickens he owns. They leave and I never hear from them again.)
I always get sideways looks from people when I say this: turning a profit is not a bad thing.
Yes, you’ll have to pay tax on that profit, and that stinks. And yes, of course you should deduct everything you possibly can.
But when you show losses in a business venture, that means you spent more money than you brought in. When that happens for a year or two, that’s no big deal and is in fact normal for businesses just getting started.
But if the losses continue beyond the startup phase, that’s a problem. Even if it’s a side business.
Let’s go back to our “goat” example above. Let’s just presume that this is a real business and not a hobby. The taxpayer is spending thousands of dollars on their goats. Yeah, they get a tax writeoff. But let’s look at it from a cash-flow standpoint.
Tax savings on $7,700: 7,700 * .22 = 1,694*
Net cash outflow on the goats: $7,700 – 1,694 = $6,006
(*-For this example, let’s presume that the taxpayer is in the 22% tax bracket in 2018.)
On the surface, this sounds like a great thing for the client. They save almost $1,700 on their tax bill!
YEAH, TAKE THAT, STUPID GOVERNMENT!!!!!
But hold on. This taxpayer hasn’t really “saved” anything …. They spent $7,700 to save $1,700 in taxes — BUT THEY ARE STILL IN THE HOLE A NET OF $6,000 OF NEGATIVE CASH FLOW.
Let’s forget about the IRS and the “hobby loss rules” for a minute here, and let’s just say that this scenario plays out year after year, which seems to be what a lot of people WANT. (Ignoring the IRS/audit implications lets us focus just on the cash flow issue.)
This client is throwing away $6,000 per year in their goat “business.” Yes they “save” $1,700 per year on their tax liability and I suppose that makes them feel better that the government is not getting that money from them.
But the $6,000 net cash outflow is a real cost that the client has to absorb. Think of the things they could do with that $6,000.
I do want to add: spending $6,000 a year of net cash outflow on goats might be worthwhile for the client because they enjoy raising goats and it brings them a sense of satisfaction that they wouldn’t have from, say, putting $6,000 into a retirement account. That’s a fair enough counterpoint.
But this gets back to something I always tell my clients: don’t spend money on something just because you might get a tax deduction, because the savings are not dollar-for-dollar — you’re still netting out in the hole.
If you’re spending money on something because your business needs whatever it is that you’re buying, then great, take the deduction.
Otherwise, you’re tossing money around trying to chase tax deductions.