Omar Bennett
Understanding what constitutes being engaged in business is crucial for tax purposes, and it involves examining various factors and regulations. The definition of a business for tax purposes is straightforward: it refers to a tax imposed on business income. However, the complexity arises when determining whether an activity qualifies as a trade or business, which offers several benefits, including deductions for ordinary and necessary business expenses. The Tax Cuts and Jobs Act (TCJA) has added pressure on taxpayers to distinguish trades or businesses to take advantage of specific tax benefits. To be considered engaged in business, factors such as continuity and regularity of activities, the primary purpose of income or profit, and the distinction between multiple trades or businesses come into play. Additionally, specific requirements, such as having a physical location, employees, or representatives in a particular state, like Texas, can determine whether a business is subject to state taxes. The business structure, including sole proprietorship, partnership, or corporation, also influences tax obligations. Understanding these nuances is essential for taxpayers to navigate their tax responsibilities effectively.
| Characteristics | Values |
|---|---|
| Primary purpose | To make a profit |
| Activity | Must be carried out with continuity and regularity |
| Business location | Must have a physical location in the state |
| Employees | Must have employees or representatives in the state |
| Services | Must provide services using company employees or authorized agents in the state |
| Sales | Must sell taxable items or services in the state |
| Ownership | Must have at least 50% ownership interest in the state |
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What You'll Learn
The primary purpose must be income or profit
The primary purpose of a business must be income or profit. This means that the main reason for carrying out any business activity must be to make a profit. It is not necessary to make a profit every year, but the intention must be there. The IRS will look at whether a business is making a profit or behaving as if it wants to make a profit. This is determined through the profit test and the behaviour test. If a venture earns a profit in three out of five consecutive years, the IRS assumes that the business has a profit motive.
The IRS may consider a business a hobby under certain circumstances. If activities are primarily meant to incur losses or are done for entertainment, the IRS may not consider it a business. To avoid this, a business owner must convince the IRS that their activities are primarily meant to earn a profit.
The Supreme Court's holding in Groetzinger, 480 U.S. 23 (1987) stated that an individual's legal gambling activities were considered a trade or business because they were conducted with continuity and regularity, and for the primary purpose of earning income or making a profit. This case set a precedent for determining whether an activity is a trade or business for tax purposes.
To demonstrate that a venture is a business and not a hobby, it must be shown that it is carried out in a business-like manner. This includes maintaining separate business bank accounts, keeping business records, and making efforts to market the business through websites, business cards, and advertisements.
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Taxpayer must be involved with continuity and regularity
For a taxpayer's activities to be considered a trade or business, they must be involved in said activities with continuity and regularity. This means that the taxpayer must engage in the activity repeatedly and consistently over time. Sporadic or one-off activities do not qualify as a trade or business.
In the case of Gentile, 65 T.C. 1 (1975), the Tax Court held that a gambler was not carrying on a trade or business because something more than income production was required. However, in Groetzinger, 480 U.S. 23 (1987), the Supreme Court contradicted this by ruling that legal gambling activities conducted with continuity and regularity for the primary purpose of earning income or profit could be considered a trade or business.
To demonstrate that an activity is carried out with continuity and regularity, taxpayers should be able to show that they engage in the activity with a profit motive. This can be established through the profit test and the behavior test. If a venture earns a profit in three out of five consecutive years, the IRS presumes a profit motive. Additionally, taxpayers should behave as if they intend to make a profit, such as maintaining separate business accounts, keeping business records, and marketing their services.
It is important to note that a business can be conducted from home, full-time or part-time, as long as the taxpayer works at it regularly and continuously. The specific facts and circumstances of each case are essential in determining whether an activity constitutes "carrying on a business". For example, in Texas, a business is considered engaged in business if it has a physical location in the state, such as a kiosk, office, or warehouse, or if it has employees or representatives selling or delivering taxable items within the state.
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Profit test and behaviour test
The IRS uses the profit test and the behaviour test to determine whether a taxpayer is engaged in a qualified trade or business.
Profit Test
The profit test is used to determine whether a taxpayer is operating a business or producing/intending to produce a profit. It is not necessary to earn a profit every year to qualify as a business. However, if a business does not pass the profit test, all of the claimed business expenses and relevant tax credits would be disallowed, resulting in a hefty tax bill. The CRA defines a business as "an activity that you conduct for profit or with a reasonable expectation of profit." The profit test asks: "Was the activity conducted with an actual expectation of profit?" and "Was that expectation of profit reasonable?" The easiest way to pass the profit test is by proving that your business has turned a profit. This can be shown with a profit and loss statement. However, if your business has not yet produced a profit, you can still pass the test by demonstrating that you had a reasonable expectation of producing one. Criteria that can prove a reasonable expectation for profit include investments, education, qualifications, the length of time over which a profit could reasonably be expected, the ability to secure proper and reasonable financing, the degree of effort in promoting and marketing the products or services, the nature of the product or service supplied, and the type of expenditures claimed.
Behaviour Test
The behaviour test is used to determine whether a taxpayer behaves as if they want to earn a profit. To pass the behaviour test, you must show that you carry on your enterprise in a business-like manner. This includes maintaining a separate checking account for your business, keeping good business records, and making an effort to market your services, for example, by having a business website, business cards, and advertisements.
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Tax benefits for specific types of trades or businesses
The definition of a "trade or business" is essential to understanding the tax benefits for specific trades or businesses. The term "trade or business" generally includes any activity carried on for the production of income from selling goods or performing services. It is not limited to integrated aggregates of assets, activities, and goodwill. To qualify as a business, an entity must demonstrate that its primary purpose is to make money. This can be done through the profit test and the behaviour test, where the IRS examines if the entity earns a profit in three out of five consecutive years and behaves as if it wants to earn a profit.
For taxpayers to take advantage of certain tax benefits, they must distinguish separate and specific types of trades or businesses. This distinction is important, as taxpayers may find it advantageous to segregate their trades or businesses to maximise tax benefits. For example, under Section 199A of the Tax Cuts and Jobs Act, eligible businesses can deduct up to 20% of their Qualified Business Income (QBI) and significantly reduce their taxable income. To qualify for this deduction, taxpayers must meet specific income thresholds and accurately document or restructure operations to avoid Specified Service Trade or Business (SSTB) classification.
The type of business entity also influences how the QBI deduction is calculated and applied. Sole proprietors, partnerships, and S corporations have unique characteristics that affect the deduction. For instance, partnerships must carefully coordinate reporting and allocation among partners, as guaranteed payments do not qualify as QBI. S corporations must also be mindful of payroll taxes, as reasonable compensation paid to shareholder-employees does not qualify as QBI.
Additionally, aggregation elections allow businesses with multiple qualified trades or businesses to combine them for QBI deduction purposes. This strategy benefits businesses with shared ownership, common control, or interdependent operations by enabling them to pool income and expenses. To qualify for aggregation, businesses must demonstrate at least 50% common ownership and meet specific criteria related to providing similar products or services.
Understanding the specific tax benefits and requirements for different types of trades or businesses is crucial for taxpayers to maximise their tax advantages. The regulations and guidelines provided by the IRS aim to ensure that only legitimate business activities benefit from these tax benefits.
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Taxpayer's specific facts and circumstances
Taxpayers' specific facts and circumstances are essential to determining whether their activities constitute "carrying on a business". This determination is crucial for understanding what qualifies as a trade or business for tax purposes and claiming associated benefits.
Firstly, taxpayers must demonstrate that they engage in their activity with continuity and regularity. Sporadic activities or hobbies do not qualify as a trade or business. For example, in Gentile, 65 T.C. 1 (1975), the Tax Court ruled that a gambler was not engaged in a trade or business because income generation alone is insufficient. However, in Groetzinger, 480 U.S. 23 (1987), the Supreme Court contradicted this by holding that legal gambling activities conducted with continuity and regularity for the primary purpose of earning income constitute a trade or business.
Secondly, taxpayers must show that their primary purpose for engaging in the activity is to generate income or profit. While it is not necessary to demonstrate profitability every year, taxpayers must provide evidence of their profit motive. The IRS uses the profit test and the behaviour test to evaluate this. Profitability in three out of five consecutive years indicates a profit motive. Additionally, taxpayers should maintain separate business accounts, accurate records, and actively market their services to exhibit behaviour consistent with profit-seeking enterprises.
Thirdly, taxpayers with multiple activities must distinguish between their trades or businesses. This distinction is essential for claiming certain tax benefits, such as deductions for business interest under Section 163(j) and qualified business income (QBI) under Section 199A. For instance, a manufacturer providing in-house legal counsel would not be considered engaged in the trade or business of providing legal services.
Finally, taxpayers should be aware of state-specific requirements. For example, in Texas, engaging in business refers to having a physical location, employees or representatives, or providing services using company employees or subcontractors within the state. These specific facts and circumstances vary across states and impact tax responsibilities.
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Frequently asked questions
Business tax is a tax on business income. The business tax laws that came into effect in 2018 set a flat rate of 21% for all corporations. Sole proprietors and pass-through businesses may pay more.
To be considered engaged in business, one must be involved in an activity with continuity and regularity, and the primary purpose must be to generate income or profit. Sporadic activities, hobbies, or amusement diversions do not qualify.
To prove that you are engaged in business, you must show that you carry on your enterprise in a business-like manner. This includes maintaining a separate checking account for your business, keeping good business records, and making an effort to market your services.
The IRS may consider your business a hobby if your activities are primarily meant to incur losses or for entertainment. To avoid this classification, you must demonstrate that your primary intention is to earn a profit. It is not necessary to make a profit every year, but you must show that you behave as if you want to earn a profit.
To determine if you have a qualifying trade or business, you must understand the requirements to identify your separate trades or businesses. The IRS uses the definition of a trade or business under Sec. 162(a), which allows taxpayers to deduct all ordinary and necessary expenses paid during the tax year.
