Pension Pete asked: So when you say the client is no longer self employed I’m wondering what you mean. In other words, if he delivered newspapers in the morning or sold pencils in the park wouldn’t he be self employed? Isn’t the notion of being self employed more of an intellectual exercise rather than factual (although maybe deductions wouldn’t be allowed if zero net in 2 out of 5 years???)? I am both self-employed and a common-law employee. Although I usually earn a little in my SE practice annually, allowing me to deduct other stuff, even if I don’t have any net earnings I would consider myself to be SE.
I answered Pete: Someone may be both an employee and self-employed. So, yes, he may be an employee of a pension company and legitimately sell pencils as his indie business.
However, self-employment is absolutely not an "intellectual exercise." There are specific IRS regs that determine self-employment. Take a look here for an overview: It's all about relationships: Are you an employee or are you self-employed?
The corporations that are kicking out employees through the front door and then bringing them back in through the rear door as "consultants" are breaking the law. Saves the corporation a whole lot in payroll taxes and benefits -- approximately 25% to 30% of salary. The IRS is trying to crack down on that but not doing a good job at it.
Or, let's look at -- wife earns $300,000 a year at her corporate job. Hubby is into photography. Wife pays for all the expensive photo equipment and the travel to the Amazon, New Zealand, and Peru for nature photo shoots. Oh, says their CPA, Sammy Segar, I think hubby is in the business of photography. Get him to sell a couple photos to friends for a few hundred dollars and we can write off all his photo expenses because he is self-employed. Here we've got a home-made tax shelter -- albeit a fraudulent one.
Sammy's shenanigans damage the credibility of legitimate photographers who happen to have a bad financial year. Why? Because it's much easier for the IRS to go after individuals than to pursue entire companies or industries. And the IRS lumps hubby together with the legitimate wedding photographer, Billy Bridesnapper.
And, any of you who follow my writing know that any 2 or 3 year profit rule is ... well You must have a profit in 3 out of 5 years: Hogwash!!