The Treasury Department's watchdog group thinks it smells a rat when it comes to reports of Schedule C losses on tax returns, and it's urging changes in the Tax Code to establish "bright-line" rules for determining when an activity is a legitimate business.

The Treasury Inspector General for Tax Administration issued a report this month estimating that about 1.5 million taxpayers filed a Schedule C showing no profits and only losses over four consecutive tax years for their businesses. Tax practitioners helped 73 percent of these taxpayers to prepare the returns.

TIGTA estimated that by claiming the losses to reduce their taxable income, about 1.2 million taxpayers potentially avoided paying a total of $2.8 billion in taxes for 2005. The analysis showed that 332,615 high-income taxpayers received the biggest benefit by potentially avoiding about $1.9 billion in taxes for 2005.

Section 183 of the Tax Code already contains a "hobby loss" provision that is supposed to limit the ability of wealthy people who have multiple sources of income to apply the losses they incur in their sidelines as a way to reduce their overall tax liabilities. But TIGTA pointed out that there are no specific criteria for the IRS to use to determine whether a Schedule C loss is a legitimate business expense unless it audits the taxpayer's books and records.

The Tax Code and the Treasury regulations don't even require a taxpayer to have a reasonable expectation of making a profit. The taxpayer just needs to have the "objective" of making a profit. But if that profit never comes, taxpayers can just go on deducting their Schedule C losses year after year.

The IRS is agreeing with TIGTA on this one. The agency said it plans to take the appropriate corrective actions, which could mean changes in Section 183 to establish those bright-line rules for distinguishing legitimate businesses from not-for-profits. That could spell trouble for taxpayers and tax preparers who are accustomed to including Schedule C with their returns, especially if they're mainly using it to shave some money off their tax liabilities.

However, setting up those bright-line rules may not be so easy. Let's face it. Almost every business has its ups and downs. Just because a business, especially a small one like the typical Schedule C venture, fails to generate a respectable return on investment in its first few years does not mean it should be abandoned, especially if there's a good chance of making more money down the road.

But the IRS may soon be taking a hard look at how legitimate a sideline business really is. If it looks and smells like a nonprofit or, even worse, just an excuse to write off household or travel expenses for a mostly fictitious business, the tax authorities could start saying no.

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