The Easy Way to Thwart the Hobby-Loss Rule
The hobby loss rule-of-thumb applies to sole proprietors filing a Schedule C. One of the surest ways to prove you are serious about doing business is to form a separate business entity. Businesses are separate entities for tax purposes. Setting up a business for your freelance writing will provide a way for you to separate your personal income and expenses from your business income and expenses.
If you decide to incorporate, there are several varieties of business entities you can choose from, each with its own tax structure.
C-Corporation. Regular corporations are sometimes called "C-Corps" to distinguish the regular corporation from a newer counterpart, the Subchapter S Corporation, or "S-Corps." Regular corporations are completely separate entities. They have their own tax identification number, and they file their own tax returns. If a corporation has a loss, that loss carries forward to offset next year's profits. Corporations can have several years of losses, and the accumulated losses carry forward to offset future profits. Entrepreneurs can realize significant tax benefits by forming a corporation. Let's say Mary, a freelance writer, has a loss in year 1 of $10,000, followed by a loss in year 2 of $5,000. In year 3, Mary's company makes a profit of $50,000. The accumulated losses will reduce that profit to only $35,000. Mary cannot deduct these business losses on her personal tax return. The losses are retained by the company, and are used to offset future profits.
S-Corporation or Partnership. These are called "pass-through entities." Basically, these businesses are not taxed at the corporate level.
Instead, any profit or loss is "passed-through" to the shareholders. The shareholders report the profit or loss on their personal tax return. That means all profits are taxed on the shareholders' tax returns. If an entrepreneur has at least one other business partner, they can form a partnership. If there is the only one shareholder, an S-Corp can be formed. Both S-Corps and Partnerships report their profit or loss on a business tax return, but issue Form K-1 to each shareholder to report the shareholder's share of profit or loss. Let's say Mary, a freelance writer, forms an S-Corp, with the same losses as the regular corporation above: Year 1 loss of $10,000; Year 2 loss of $5,000; and Year 3 profit of $50,000. In year 1, Mary would report her loss on Schedule E, and the loss would reduce her total income. In year 2, likewise, the loss would reduce Mary's total income. In year 3, Mary would report a profit, and her total income would increase. Partnerships and S-Corps cannot retain their own profits or losses, and so the profit in year 3 cannot be reduced. That's because the losses were already distributed to the shareholders. There is one significant audit risk with a partnership or S-Corp. It is assumed that the shareholder works for the S-Corp or partnership, and so the IRS expects part of the shareholder's income will be taxable wages, and part will be profits from the business. In order to avoid an audit, Mary would have to pay herself a reasonable salary, and pay tax on the salary, even though the business isn't making any money.
Limited Liability Company. Much has been written about the Limited Liability Company, or LLC. The LLC is designated by the state where the business incorporates. The LLC is not a federal tax entity. An LLC is taxed as a partnership at the federal level. Or, if the LLC chooses, it is taxed as a C-corporation. If the LLC has one and only one shareholder, the LLC may be a "disregarded" entity and taxed instead on the 1040 Schedule C.
If you decide to incorporate, there are several varieties of business entities you can choose from, each with its own tax structure.
C-Corporation. Regular corporations are sometimes called "C-Corps" to distinguish the regular corporation from a newer counterpart, the Subchapter S Corporation, or "S-Corps." Regular corporations are completely separate entities. They have their own tax identification number, and they file their own tax returns. If a corporation has a loss, that loss carries forward to offset next year's profits. Corporations can have several years of losses, and the accumulated losses carry forward to offset future profits. Entrepreneurs can realize significant tax benefits by forming a corporation. Let's say Mary, a freelance writer, has a loss in year 1 of $10,000, followed by a loss in year 2 of $5,000. In year 3, Mary's company makes a profit of $50,000. The accumulated losses will reduce that profit to only $35,000. Mary cannot deduct these business losses on her personal tax return. The losses are retained by the company, and are used to offset future profits.
S-Corporation or Partnership. These are called "pass-through entities." Basically, these businesses are not taxed at the corporate level.
Instead, any profit or loss is "passed-through" to the shareholders. The shareholders report the profit or loss on their personal tax return. That means all profits are taxed on the shareholders' tax returns. If an entrepreneur has at least one other business partner, they can form a partnership. If there is the only one shareholder, an S-Corp can be formed. Both S-Corps and Partnerships report their profit or loss on a business tax return, but issue Form K-1 to each shareholder to report the shareholder's share of profit or loss. Let's say Mary, a freelance writer, forms an S-Corp, with the same losses as the regular corporation above: Year 1 loss of $10,000; Year 2 loss of $5,000; and Year 3 profit of $50,000. In year 1, Mary would report her loss on Schedule E, and the loss would reduce her total income. In year 2, likewise, the loss would reduce Mary's total income. In year 3, Mary would report a profit, and her total income would increase. Partnerships and S-Corps cannot retain their own profits or losses, and so the profit in year 3 cannot be reduced. That's because the losses were already distributed to the shareholders. There is one significant audit risk with a partnership or S-Corp. It is assumed that the shareholder works for the S-Corp or partnership, and so the IRS expects part of the shareholder's income will be taxable wages, and part will be profits from the business. In order to avoid an audit, Mary would have to pay herself a reasonable salary, and pay tax on the salary, even though the business isn't making any money.
Limited Liability Company. Much has been written about the Limited Liability Company, or LLC. The LLC is designated by the state where the business incorporates. The LLC is not a federal tax entity. An LLC is taxed as a partnership at the federal level. Or, if the LLC chooses, it is taxed as a C-corporation. If the LLC has one and only one shareholder, the LLC may be a "disregarded" entity and taxed instead on the 1040 Schedule C.
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