Establishing Regular and Active Involvement in a Business

Business expenses are certainly a routine part of doing your taxes. However, you should keep detailed records of your deductions, and make sure that they are legitimate. One would-be author found this out the hard way, when he attempted to claim $19,000 in travel expenses for his book – which was never written.

Claiming tax deductions

In 2006, a man took time off of his regular job to embark upon a world trip with the intention of writing a book about it. He had no book contract and was not a published author. On his return, he attempted to take a business loss for the expenses he incurred on the road, but the IRS slapped him with a $5,000 fine in back taxes and an additional $1,000 penalty.

What he did right

The man had a detailed business plan in place outlining the purpose of his trip and how it applied to his book. He also kept an expense log, documenting each expense and noting the corresponding date and location. His claim was that the overall trip itself was a research trip, which should then be tax-deductible.

What he did wrong

This case appeared in front of the 9th Circuit Court of Appeals in 2011, nearly 5 years after his trip concluded. At this point, there was no published book. In fact, there was no book at all. The tax court was interested in proof that he was regularly and actively involved in the business. The fact that the business of writing the book never took place counted against the wannabe author. So, too, did the fact that his expense log did not include information on the business purpose of each expense. This lead the court to decide that he was not repeatedly in business of an author.

He was required to pay $5,000 in income taxes from the period, but the penalty fine was dropped because he acted in good faith by consulting a tax professional.

Establishing regular and active involvement in a business or trade

This story sounds like a nightmare scenario to many of us, but it is also easy to see why it happened. In order to claim active involvement in a business, an individual must be able to meet certain criteria. In general, the taxpayer must show that they work on a regular, continuous, and substantial basis in the business or trade.

The 4 Types of Businesses

The survival of your business depends on you knowing the type of business you are now doing. Only then would you be able to identify the gaps and directions to take in order to prevent a premature demise or non growth of your business.  

The economy can go up and down over a 9 to 11 year cycle; countless number of business appear and disappear with this cycle. Can yours ride out the storm like McDonald’s, Coca Cola or Nike? Would you like to be able to? 

Type #1: Blooming Flower
In 2005, a high ranking official from the Singapore Economic Development Board release their findings; 80% of all small and medium size businesses never survive pass their 42nd month.  These are the businesses they came and are now gone.  It is like a blooming flower, when in full bloom, they are nice to look at, smells good too.  However, they soon wither off, slowly decaying and smells really bad as they rot before they finally nail it.

Does it mean that it was a bad or wrong business, well no, they are all good businesses.  Their final demise could be a whole complex multitude of cause and effects.

If you think your current business matches this type, what do you think you could do to prevent its premature demise?

Type #2: Fireworks
These types of business comes out in a big bang and then as suddenly as they appear, they disappear.  One such business I saw in Singapore is “Bubble Tea”; it is a concoction of red tea with milk and small starch balls.  When it first arrived in Singapore, it came with a big bang, its outlets were everywhere.  At its peak, there was even an outlet in a heartland town that employed sexily dressed models during its peak hours to promote their product.  It sure raised a lot of eyebrows among the women in the heartlands.  The frenzy peaked out around the 9th to 11th month and then it fizzles out of fashion.  Today, we can still find one or two stalls in the heartlands and prices have tumbled by more than half compared to the charges during its peak.

Another example would be “Roti Boy”, they only have a single product, a bun with a butter based caramel filling and a layer of coffee cream on the top.  Baked to perfection the coffee cream turns into a crispy crust that adds to the flavor of the bun.  There were long queues at its early outlets and soon, outlets sprout all over the place.  Just as they appear suddenly, they fizzle out just as fast.

If you have a business in this category, I must say you are either really smart or …  Smart is if you are the type of businesspersons who are great at starting a business and then selling it off at its peak for a good profit.  However, if you are in for the long run well then you are … eh … not smart.

So, please share with me what would you do ?

Type #3: Bonsai Plant
This type of business are usually around for more than twenty years, they are still around, but they are just as they were 5 years ago, 10 years ago, 15 years ago, some are still the same as when they started.  These would be the small business stores you see along the streets.

So why do we classify them as a Bonsai Plant, well they are still in business, just as a bonsai plant is alive.  However, like a bonsai plant, which is actually a large tree, it kept its bonsai size due to purposeful potting.  These businesses have the potential to be as big as a tree and could even reach the status of a Type #4 business, but they stayed as they were.

Some use the analogy of a frog to describe these type of business, they sit pretty and still on their patch and wait for their prey (customers) to come by in front of them, then they lash their sticky tongue out and devour them.  When there are no customers, they sit and curse the government, the economy and lament their sad state.

These business are typically family run.  Granddad started it off, handed it over to Dad, who raise the whole family tree with it and now it is your turn.  You don’t like the business, but you are obliged to take it.  You can choose to sit and let it carry on as it has over the last 20 or 30 years and it will carry on for another 10 or 20 years.  It won’t kill you, on the contrary it would feed you and your family tree.  But it would be like sleeping with a pea under your bed sheet.

So, are you here ?

Type #4: Pine Tree Forest
This is the one every business should attain.  At this stage the business is highly structured with proper controls.  The most important of all, it’s profitable business unit is duplicable across national boundaries.

A great example of such a business is McDonald’s.  You can be in Beijing and the McDonald’s there will provide you with the same familiar furniture in their outlet, they same tasting burgers and fries.  You will be greeted in exactly the same way be it McDonalds in Singapore or McDonald’s in Australia.  When McDonald’s is ready and allowed to open an outlet in North Korea (in some peaceful future), it will also look exactly the same in their deco, the same looking counter, the same cash register, etc.  Does that mean the business is no longer innovating? Nope, they are ever more innovative and adaptive to local conditions.

Take for example Mr MacDonald full size figure does not sit with cross legs in Thailand because in Thailand, it is rude to sit cross leg, so Mr MacDonald adapt to the local culture.  If you have seen how the MacDonald fries were made in America, well they are made in exactly the same manner in the same fryer of the same size in McDonald’s Philippines.

Take another example of a  “Pine Tree Forest” type business; Kentucky Fried Chicken.  They too have a very similar duplicable business model to McDonald’s.  They too, were very adaptive to local cultures, so when in Indonesia, where the culture prefers to accompany their fried chicken with rice rather than a bun, Kentucky Fried Chicken sells their meal sets with a ball of rice in place of the bun.

So, when McDonald’s wants to start their first outlet in Afganistan (in the peaceful future), they simply take out the Standard Operating Procedures (SOP) and follow exactly as it is written, right from the glass doors down to the kitchen cutlery.

What do you think is McDonald’s & Kentucky Fried Chicken’s Unique Selling Proposition? … Comfort Meal – familiar surroundings for a familiar meal, anywhere.

Would you like to grow your business to a “Pine Tree Forest” type ?  Do you know how ?

Today in History – What Happened on the 9th of June

68 – With the provinces and his own Praetorian guard rebelling against him, and having now been declared a public enemy by the Roman Senate, Emperor Nero committed suicide saying “What an artist the world is losing in me!”

1623 – British negotiators, who were finalising a treaty with the Indians near Potomac River in North America, offered a toast “symbolising eternal friendship”. Chief Chiskiack, his family and advisers, numbering 200 in all, drank the toast and immediately died of the poisoned drink. The British drank their toast from a different container.

1870 – Charles Dickens died after having suffered a stroke the day before. At the time he was writing Chapter 22 of his fifteenth novel “The Mystery of Edwin Drood”, a work of 44 chapters which he was writing in monthly installments. As a result, the real outcome of the story remains a mystery to this day!

1902 – Frank Hardart and Joe Horn began the fast food business with the opening of the first Automat eatery at 818 Clarence Street in Philadelphia. By inserting three nickels (15 cents) into a slot and turning a handle, diners could help themselves to a fabulous selection of food – all made fresh that morning. They had got the idea for the automat from seeing a waiterless restaurant in Berlin. The last Horn and Hardart Automat, located in New York, closed its doors in April 1991.

1910 – A passenger aboard the steamship “SS Arawatta” wrote a message which was placed in a bottle and thrown overboard between Cairns and Brisbane. It was found 6 June 1983 – 73 years later almost to the day – on Moreton Island off the Queensland coast. (At the time this set a world record for the longest time between sending and finding a message in a bottle. It has since been broken in 1996 when a fisherman found a bottle in the North Sea which had been in the water for 82 years and which made the offer of a small reward if returned. The fisherman collected £1 from the British Government.)

1934 – Donald Fauntleroy Duck made his first appearance. He appeared in a cartoon entitled “The Wise Little Hen” in which Donald and his friend, Peter Pig, sole members of the Idle Hour Club, refuse to help a mother hen with planting and harvesting corn. When all is finished and corn delicacies are on the table, Donald and Peter, now interested, are not invited. Walt Disney had wanted to add a duck named Donald to Mickey Mouse’s gang for some time but it was not until he heard Clarence Nash on a radio show doing his now famous “nash-speak” that he was able to realise his goal. He hired Clarence Nash and the rest is history.

1994 – In North Yorkshire, England, car thieves stole British Home Secretary Michael Howard’s bulletproof car while he was a attending a meeting of police chiefs. The car was found later minus all four wheels.