I’m always being asked for the best tax tips to manage financial losses. In a recent edition of TalkBiz News, Paul Myers described a common problem—paying someone thousands of dollars and getting nothing in return. He wrote:

One guy I spoke with recently spent $7,000 with someone who failed to deliver anything he promised. The guy was so distraught that he was talking about suicide. Where he lives, that’s a lot of money. His wife is threatening to leave him, he’s got no money left even for bills, and he’s got no idea how to fix things.

Paying taxes on a failed business

The IRS’s first instinct when looking at a failed business is to consider it a hobby. When you have a hobby, you’re only entitled to deduct your expenses up to your income. Under the hobby-loss rules, your business never got far enough to generate any income, so there’s no deduction. This means that you want to ensure that the IRS instead sees this failed venture as a real business and not a hobby.

Deducting a capital loss

When a real business fails at the outset, you can deduct the investment on Schedule D as a capital loss. Doing that, you’re limited to $3,000 per year over any capital gains you might have. That $7,000 investment made by Paul’s friend could take three years to generate tax benefits.

Deducting start-up costs

An aggressive tax professional might try to report the whole operation on Schedule C as business expenses and start-up costs. You may have a problem with that because the business needs to have its doors open in order to deduct start-up costs. However, if you could build a good argument for these costs to be business expenses, you could write them all off in the year you paid the expenses.

Reporting losses after losing money to a scam

If you can prove that the person you hired intended to defraud you from the outset, you may be able to treat the costs as theft or casualty losses. In order to do that, you would have to file criminal charges against the individual. That’s rarely going happen—but, when you’re angry enough, you’ll do it. As a theft loss, you can deduct all the costs in the year you discover you’ve been defrauded.

Investing vs. gambling

You can avoid this disaster in the first place. When you’re married and/or you have a family, it’s flat-out irresponsible to risk the rent on an Internet venture or some other long-shot scheme. It’s also a risk when you have to pay someone thousands of dollars to do something you don’t know how to do yourself, especially when you must rely on the other person’s own hype. Like Paul’s friend, you will only end up hurting your credit score, your marriage—and, alas, your life.

Instead, when you have a project you strongly believe in, do your homework. Learn everything you need to know to put the project together. There are plenty of free and inexpensive resources online to help you. There are community redevelopment organizations, and the retired executives at SCORE can also advise you. Once you really know the ropes, not only will you succeed without risk but you might also attract investors to fund your business.

Eva Rosenberg, EA, is the publisher of TaxMama.com®, where your tax questions are answered. She teaches tax professionals how to represent you when you have tax problems. She is the author of several books and e-books, including Small Business Taxes Made Easy. Follow her on Twitter: @TaxMama