My husband is in the process of starting a piano business. He purchased $3000 worth of supplies. He has not sold any pianos or purchased any to restore and sell. Can we deduct this $3000 from our taxes?
To answer your excellent question, I have to first ask you four questions – the same four questions that the IRS will ask you if they decide to audit you:
1. Is this really a business?
In the tax law, business is different from a hobby. In plain English, business is something you realistically expect to make a profit and something you actually put a real effort into. This informal definition sounds very broad, but it excludes two kinds of activities:
- Something that you do because you enjoy it and will continue doing, with or without profit. A good example would be photography: you won’t mind getting paid for shooting a friend’s wedding, but you would continue spending money and time on this hobby even if you never make a penny out of it. In this case, it is not a business, for tax purposes.
- Something profitable that you do occasionally, whenever a chance happens, but you are not actively trying to find work. Let’s say you know how to bake a killer cake. Your friends know that, too. Once in a while, they would ask you to help them impress their guests, and you would oblige, making a few bucks in the process. Otherwise, you do not market your enviable skills and have no intention of spending long hours watching your oven. This is not a business, either.
Hopefully, these two examples will help you decide whether your husband can legally label his project a business.
2. Did these expenses qualify as business expenses?
The key is that, to be tax-deductible, business expenses must be specifically related to your business and be “normal” in your type of business. Again, this is an informal definition, and I discuss this issue in more detail in my “Business expenses” article.
3. Did the business start last year?
This one is a tricky but a very important question. If your husband’s business started last year, you can deduct his business expenses on your last year’s tax return. Assuming, of course, that the expenses were paid last year.
If, however, the business did not start until this year, his last year’s expenses may not be deducted last year. Such expenses become what is known as start-up costs, or expenses incurred before the business starts. They become deductible in the year when business does start – which could be this year, in your case. If so, you have to wait another year before declaring your husband’s expenses on tax return.
The actual date when the business starts may be unclear. Legally, it should be the date when the business first attempted to generate money, as opposed to merely getting prepared for such day. In other words, it’s when you first tried to make money and not just spend money for future business.
If it was a restaurant or a retail store, then it’s easy: the start date is the date your business was open to customers. With a business like yours, the start date is somewhat subjective. It could be the date when you received your first order. It could be the date when you first advertised your business in a local paper. It could be the date when your husband started distributing flyers or business cards. Either way, it must be the date when he was ready and open for business. When you say “in the process of starting”, it makes me think he has not started yet. More importantly, it makes the IRS think that way, too.
4. Do you want to wait another year?
Let’s say you answered yes to the previous 3 questions. Then you legally can deduct business expenses on your last year’s tax return. You can, but do you want to? It is not such a strange question when you think about the IRS audit risk.
If you do deduct these expense last year, you will be claiming having a business that had zero income but $3,000 in expenses. In other words, a business that loses $3,000 while making nothing. No surprise if the IRS might consider it suspicious. And they do. Small businesses that claim losing money are a favorite target of the IRS audits, especially when the reported income is zero.
You may be able to win if you are audited by the IRS. If you convince them that the business did start last year and all expenses were legitimately deductible – you win. But is it worth the hassle? In many cases, it isn’t. You may be better off waiting another year until the business starts making money, and then you will deduct last year’s expenses on this year’s tax return, as start-up expenses.