I have over 80 clients that still report their business income on Schedule C (Sole Proprietorship).  A lot of these businesses have truly been trying to create an income, but continually show losses.  I have seen more audits of these in the past 2 years than I have in the previous 20 years all put together.  Clearly the IRS is scrutinizing the small businesses very carefully and with some good reason.

The logic is that if it truly is a business and you lose money more than 2-3 years in a row, you will quit doing it.  This is particularly true if you have another income stream that clearly supports you, i.e. a spouse with a W-2, Interest, Dividends, Pension, Social Security etc.  The truth is a lot of people have been claiming their Hobby (everything from jewelry making and art work to Mary Kay cosmetics)as a loss to simply lower their taxes.  I have had some Schedule C audits prove that they are truly trying to make an income and the IRS has allowed it.  These are businesses that the Taxpayer has produced income in the past from, has invested a substantial amount of money in the tools needed to that business, and have very little "other income".  These can be web designers, small contractors, consultants etc.

If the IRS does Audit your small business and determines that it is a Hobby, here is what happens.  You will pay both income tax and social security and Medicare on your GROSS income from that business.  You will only be allowed to claim your expenses as Itemized Deductions.  That can be a huge penalty for those Taxpayers.