Some people view starting an inline business as a win-win proposition. That is, if the business is successful, they win because the business will bring in potentially significant amounts of income. If the business is not successful, they may reason that they “win” regardless since they assume that will be able to “write off” their business expenses. While one can already poke holes in this view due to the fact that you can only take business deductions when you have already lost money, taking deductions due to assumed business losses isn’t always as straightforward and a matter of course.
The IRS is known to disallow business expense deductions when the agency believes that your business is actually a hobby. If you started a new business in a field that is traditionally viewed as a hobby or pastime and have lost money in all or most years, the IRS may take a second look at whether your activities qualify as a business. However, the taxpayer needs to be especially wary because the IRS’s definition of a business probably does not comport with your definition of a business. Taxpayers should review the hobby-loss rule and its nine-factor test to better understand the tax treatment they can expect.
The IRS is privy to data from businesses of all sizes and industries. The IRS aggregates and analyzes this data to better understand individual and business taxpayers. One use of this data is to detect possible fraud in the form of inflated or fabricated business expenses. If your business claims significantly greater expenses than average for its size and industry, an audit may follow.
IRS examination techniques manuals specifically contemplate the fact that certain large deductions can reveal the existence of an online business or an online component to an already existing company. The manual notes that claimed asset depreciation schedules and expenses can reveal online activities. It further states, “An unusually large amount deducted for Rental/Leasing Expense and/or Utilities may also be indicators that the company is involved in Internet activity.”