Audit Examination Report

[Jack from Ohio]

I am hoping for some help/guidance from all the knowldgeable people here.

Client was audited for 2006 and 2007. (we did not do her returns) IRS challenged her business expenses. First determination, she did not have a business, all expenses were disallowed.

We collected and submitted to the auditor information that supported that she did have a business.

Examination report just received today determines that she does in fact have a business, but reduces her expenses (all expenses well documented) to the amount of her income resulting in a $0 profit or loss.

This lady has had this business since 2004. There is no doubt she is doing it as a business.

Below each item in the explanation is this:

Schedule C has the indication of a business, but expenses were excessive - ordinary, necessary, & reasonable, we have pro-rated your expenses to income and disallowed your loss. The deduction had been adjusted to the amount verified, including carry forward expenses from 2005.

Has anyone had this situation happen? I have never seen the IRS agree there is a business, but not allow documented expenses.

Your help and advice is greatly appreciated

[jainen]

>>all expenses well documented<<

Although you were able to show that the expenses were incurred, apparently your records did not satisfy the auditor as to their business purpose. There is a general rule that expenses should be proportional to the income, especially after several years. Quite a few people have gone to court over this question so you have plenty of material to research.

You might start by claiming the auditor was too arbitrary in simply matching total expenses to total income, which I don't think is much supported by case law. Then address the specific expenses, either with key examples or by category, documenting how each contributed to a bona fide expectation of profit. This level of research and analysis takes a lot of time, so make sure you have an engagement letter and a retainer and that your client is committed to paying for your work.

Before you file your appeal, however, consider the possibility that the IRS will blackmail you with its original position that none of the expenses are allowed. I mean, it kind of sounds like the auditor was giving you a break, compromising the details to get the case closed quickly. You may have to take this all the way to Tax Court, where your chances would depend on the kind of arguments that IRS lawyers are very good at.

[RoyDaleOne]

Well, that $10,000 out of $20,000 entertainment expense seemed a bit excessive when the income was only $3,000.

If a profit motive (hobby) is not an issue it is very difficult for the IRS to maintain the position you have stated.

However, you are one to determine if the expenses were reasonable or not.

With your experience I am sure you will do fine.

[MAMalody]

I'm curious. Did the '04, '05 and '06 returns also show a loss?

[Jack from Ohio]

05 = $5,000 loss (first year in business)

06 = $200 profit

07 = $8,000 loss

The auditor did say that she had a business, based on the information we provided.

We did not prepare any of the returns discussed here. We would have prevented the issue with some lengthy dialogue and discussion about business expenses.

[jainen]

>>The auditor did say that she had a business<<

Whatever the auditor may have SAID, her ACTIONS call it a hobby loss since there is no other legal basis for the adjustment she made. It's important to note that IRS is playing hardball--the auditor started with NO expenses. Obviously she can't support that even with hobby loss rules, so she wasn't giving away too much by offsetting all the income. Her only real compromise was to let your client avoid the 2% haircut on Schedule A.

You haven't told us what sort of business this is or the nature of the expenses, but obviously the examination report is wrong on the face of it. The question now is, what realistically can you do about it? It's worth calling the auditor one more time, saying your client is prepared to sign the proposed changes but doesn't understand the calculations because there is no dispute that this is not a hobby. If she grants you another appointment, come prepared with NEW documentation so she can justify changing her mind. You might at least get some of the less controversial expenses back in.

She is not likely to throw out Schedule C entirely, but Appeals might. The IRS is concerned about potential abuse with Schedule C losses that don't represent a viable business. If Appeals continues to hang tough they may call it a hobby, and since your client didn't claim any Schedule A hobby expenses she'll get nothing. You can probably beat the Schedule A issue in Tax Court, but that's a lot of work to end up worse off than you are now.