Small Business: Avoiding Problems with the IRS

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Small Business:

Avoiding Problems with the IRS

Publication Date: September 2020

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Small Business:

Avoiding Problems with the IRS

Copyright

©

2020 by DeltaCPE LLC

The author is not engaged by this text or any accompanying lecture or electronic media in the rendering of legal, tax, accounting, or similar professional services. While the legal, tax, and accounting issues discussed in this material have been reviewed with sources believed to be reliable, concepts discussed can be affected by changes in the law or in the interpretation of such laws since this text was printed. For that reason, the accuracy and completeness of this information and the author's opinions based thereon cannot be guaranteed. In addition, state or local tax laws and procedural rules may have a material impact on the general discussion. As a result, the strategies suggested may not be suitable for every individual. Before taking any action, all references and citations should be checked and updated accordingly.

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert advice is required, the services of a competent professional person should be sought.

—-From a Declaration of Principles jointly adopted by a committee of the American Bar Association and a Committee of Publishers and Associations.

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Course Description

Small businesses must calculate the yearly income and expenses for their tax returns, and each return is unique, ranging from the part-time teacher of trumpet lessons to the large law office operating as a single member LLC.

The books and records of these businesses can range from a disheveled box of receipts, to an Excel spreadsheet, to a nice set of financials generated from QuickBooks. Certain issues or factors within a tax return are red flags, or triggers, to the IRS that may increase the likelihood of an audit. Some of these triggers are newer, due to recent changes in tax law while others have been around for so long that practitioners have grown bored with them and, perhaps, become a bit careless in confirming that their clients are complying with the requirements of the law.

The Internal Revenue Service (IRS) has published auditing procedures in their Auditing Techniques Guides (ATGs), which are available on its website. While these guides were designed for use by IRS examiners, they are also valuable sources of information for small business owners and tax practitioners who can use them when establishing their own procedures to ensure potential audit issues are addressed prior to filing tax returns.

Applying the ATGs benefits clients and also demonstrates practitioners’ due diligence in the preparation of tax returns.

The Department of Labor (DOL) has recently taken an increasingly larger role in determining how businesses should define their workers and how they should pay their workers. Many small businesses could run afoul of the DOL rules and regulations with respect to their employee relations, and it is up to practitioners to educate them about these requirements and issues. This course provides the most recent news out of the DOL.

This course takes an in-depth look at audit triggers for cash intensive businesses, the hobby loss rules, the proper classification of independent contractors and employees, and the requirements of the recent Tangible Property Regulations. This course also briefly reminds the practitioner of the requirements related to deductions for items such as meals and entertainment, travel, and the office in the home. At the end of each chapter is an Action Plan, which the practitioner can use to develop procedures that properly address these potential audit issues. By following these procedures, practitioners can go a long way toward helping their clients stay out of trouble with the IRS and the DOL.

Field of Study Taxes

Level of Knowledge Basic to Intermediate

Prerequisite Basic Taxation

Advanced Preparation None

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Section 1:

Recordkeeping and Cash Intensive Businesses

Learning Objectives:

After completing this section, you should be able to:

1. Identify taxpayers who are required to file a Schedule C.

2. Identify industries for which the IRS has published Audit Techniques Guides.

3. Recognize the important reasons for your clients’ careful recordkeeping.

4. Recognize the techniques the IRS uses in an audit to identify underreported income.

5. Recognize businesses the IRS considers cash intensive, along with businesses that are possible opportunities for underground activities.

Overview

Schedule C, the form used by individuals to report profit or loss from their businesses, is filed with Form 1040.

Each Schedule C business is unique to a specific taxpayer. This lack of uniformity comes with its own set of challenges due to the variety of businesses that are reported on Schedule C. Schedule C businesses can range from small businesses, such as craft sale businesses, to very large sole-owner/single member LLC businesses such as CPA firms. Some Schedule C businesses will have separate business bank accounts and an excellent set of financial records generated from QuickBooks or other software; however, many Schedule C businesses will deposit income into a personal checking account, with expenses paid from cash or personal credit cards with little to no tracking or reporting. Sometimes clients will deliver their disorganized receipts to a practitioner in an old shoebox. Each business reflects the personality of the owner, so if the owner is organized, then preparation of the Schedule C will generally be easier. If the owner lives in a state of constant chaos and throws his or her receipts to the floorboard of the car, preparation will be quite challenging! Practitioners know that of the total amount of time it takes to prepare an individual’s return, a ridiculous amount of can attributed to preparation of a Schedule C.

A Schedule C should be used to report the income and expenses of:

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• Self-employed individuals (NOT farmers),

• Individuals who operate side-businesses, even if the taxpayers are employed in another line of work, and

• Single member LLCs that are treated as disregarded entities for tax purposes.

Treasury Regulation §1.183-1(d) requires that a separate Schedule C be filed for each business for which the taxpayer is involved. Two businesses cannot be combined into one Schedule C. For example, income and expenses from a welding business cannot be used to offset income and expenses from teaching private trumpet lessons.

These Regs do allow consolidation of multiple undertakings into one Schedule C if the businesses/activities are sufficiently interconnected. Determining whether two businesses/activities are sufficiently interconnected is based upon the facts and circumstances of the taxpayer; however, courts generally make their determinations based on the answers to the following questions:

• Are the activities conducted at the same location?

• Are the activities performed as separate activities?

• Are the activities part of an effort to find sources of revenue from land?

• Do the activities have shared management?

• Do the activities have the same overseer?

• Do the activities share the same books and records?

• Does one activity benefit from the other?

• Does the taxpayer use one activity to advertise the other?

• Does the taxpayer use the same accountant for all the activities?

The activities reported on a Schedule C often trigger IRS audits for reasons discussed in this course. IRS audits are inconvenient, costly and stressful. Audits frequently occur during tax season, causing firms to spend a significant amount of time compiling documentation, sometimes for items that meet the definition of insignificant, into large bound manuals to hand over to the IRS examiner while also ensuring they meet their tax filing deadlines.

ALERT!

Spouses who jointly own an unincorporated business are generally classified as a partnership for federal tax purposes whether or not there is a formal partnership agreement. However, a husband and wife who are the only owners and who each materially participate in the business can elect to be treated as a qualified joint venture, and not as a partnership, by doing the following:

• Jointly file a Form 1040,

• Divide all items from the jointly-owned business in accordance with each spouse’s respective interest, and

• File a Schedule C and Schedule SE for each spouse.

Additionally, in community property states, a husband and wife can treat the business as a sole proprietorship rather than as a partnership. If only one spouse participates in the business, all of the

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income is self-employment income of the spouse who carried on the business. If both spouses participate, the income and deductions are allocated based on their distributive shares.

Statistically, the chances of being audited are quite low. But I’ve said a few times through the years that the chance of being hit by a tornado is quite low, but if you are in its path, the chance is 100%. It is the same with audits--if your client is selected for audit, his or her chance of audit just increased to 100%. Not to compare audits with tornados…well, maybe just a little.

An excellent policy is to prepare every tax return as if it will be audited within three years. As tax preparers, standard procedures should already be in place that require us –at the very least—to document in the client files every position taken and why, and every meeting, telephone conversation and email. These procedures should require follow-up on unusual items. But something happens in the heat of tax season when sometimes, in efforts to move efficiently through mountains of work, practitioners become careless. They may not follow-up on an unusually large expense listed in the client’s records, forget to get a signed engagement letter, or fail to document the telephone call in which the client told us about his business mileage. This should never happen. Tax season procedures should be established and followed on every single client every single time.

This course is a hearty attempt to remind tax practitioners (including me) to prepare for an audit before it ever happens. It is designed to assist practitioners in establishing standard procedures that address the Schedule C issues the IRS views as “hot.” This course can be viewed as sort of a storm shelter for when the tornado hits.

Audit Techniques Guides

The IRS makes available ATGs on its website for Small Businesses and Self-Employed. ATGs are used by IRS examiners during audits to obtain an understanding of the issues and accounting methods unique to specific industries. While ATGs cannot be cited as authority, they are quite useful to business owners and tax practitioners because they identify the issues that matter most to the IRS. The IRS states that the ATGs are only current through the publication date (several are > 10 years old) and as a result it provides no guarantee as to their technical accuracy after that date. The guides set forth industry-specific auditing procedures, which provide guidance on how examiners will audit income and other items, and including the questions taxpayers are typically asked upon audit. Following is a list of some of the ATGs that are available:

Aerospace Industry Air Transportation

Architects and Landscape Architects Art Galleries

Attorneys Business Consultants

Capitalization of Tangible Property Cash Intensive Businesses

Child Care Provider Coal Excise Tax

Conservation Easement Construction Industry

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Continuation of Health Care Coverage Cost Segregation Credit for Increasing Research Activities Entertainment Industry Excise Tax on Indoor Tanning Services Executive Compensation

Factoring of Receivables Farmers

Fishing Industry Foreign Insurance

Gold Parachute Hardware Timber Industry

IC-DISCs Inland Waterways

Low-Income Housing Credit §IRC 162(m) Salary Deduction Limitation

§IRC 183: Activities Not Engaged in For Profit Lawsuits, Awards, and Settlements

Ministers New Markets Tax Credit

New Vehicle Dealership Non-Qualified Deferred Compensation

Oil and Gas Industry Ozone Depleting Chemicals

Partnerships Passive Activity Losses

Place Mining The Port Project

Real Estate Property Foreclosure and Cancellation of Debt

Reforestation Industry

Rehabilitation Tax Credit Retail Industry

Sections 48A and 48B - Advanced Coals and Gasification Project Credits

Split Dollar Life Insurance Structured Settlement Factoring Timber Casualty Loss

Veterinary Medicine Wine Industry

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Another helpful aspect of the ATGs is the inclusion of Internal Revenue Code sections related to specific topics or industries, as well as other authorities (court cases, Revenue Rulings and Procedures, etc.). If codified law and judicial precedents regarding a specific issue or industry need to be researched, an ATG is a great place to begin.

Practitioners should familiarize themselves with the ATGs that are representative of their clients’ respective industries. Tax practitioners, are not required to audit their clients; however, these guides are extremely useful in identifying potential issues and red flags, some of which may be addressed or eliminated prior to filing tax returns.

Careful Recordkeeping

Every Schedule C business should have a designated bank account into which all the income from the business is deposited and from which all the business expenses are paid. There should be no commingling of the business

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and personal expenses of the owner(s). Even though every Schedule C should have a designated bank account, the reality is that many owners of Schedule C businesses run the income and expenses through the owner’s personal bank account.

Schedule C businesses, no matter how large or small, should have a system of recordkeeping wherein all bank statements, cancelled checks, deposit slips, sales contracts, invoices, purchase orders, receipts, and tax information returns are kept. Three of the most important reasons for keeping such records are:

1. Proof of income upon audit.

Upon an audit, the client will likely be required to prove the income shown on Schedule C. The client should keep all Forms 1099-MISC, 1099-NEC (beginning in 2020) and 1099-K, bank statements, deposit slips, and any other documents that can be used to prove income. In the client work papers, the tax practitioner should always have a detailed list of all the sources of gross income recognized on Schedule C.

2. IRS matching.

There aren’t many practitioners reading this course who haven’t received an IRS CP-2000 notice. An IRS CP-2000 notice is sent when the information on file with the IRS is different from what is reported on an income tax return.

This notice always begins with “the income and/or payment information we have on file doesn’t match the information you reported on your tax return.” The IRS then explains specifically what doesn’t match. The client receiving the notice has a set time to respond to the notice. Composing the response can be time consuming and put additional stress on the practitioner when the client needs a response during the practitioner’s busy tax season.

To avoid receiving such a notice, practitioners should check clients’ records carefully to ensure that all Forms 1099, Schedules K-1, and Forms W-2 have been provided. For Schedule C, the practitioner will need Forms 1099-MISC (Miscellaneous Income), 1099-NEC (Nonemployee Compensation, beginning in 2020) 1099-K (Payment Card and Third Party Network Transactions), and any other forms reporting self-employment income to the client. The practitioner should always review the prior year tax return for sources of income, and should always ask the client whether new Forms 1099-MISC or 1099-NEC (beginning in 2020) have been received in the current year.

If any Form 1099 has erroneous information, whether incorrect social security number, incorrect name or address, or incorrect amount (based on the client’s records), the issuer should be contacted to obtain a corrected form. If a corrected 1099 form is not received and the information is reported differently on the tax return, a CP-2000 will likely be generated.

Additionally, to make it easy for the IRS matching program, the tax preparer should list each Form 1099 on a schedule attached to the client’s tax return. The IRS computers cannot match each separate information return with the sum total reported on the tax return.

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3. Documentation of all business expenses.

Upon an audit, the IRS will likely request documentation for all expenses claimed on Schedule C, especially expenses related to business travel and meals. The perfect client records his or her business activity in QuickBooks or other software and keeps all receipts, credit card statements, sales records, invoices, purchase records, payroll records, bank statements and cancelled checks in labeled folders in a well-oiled file cabinet. Even more perfect is the client who scans copies of source documents into electronic files that can be uploaded to the tax practitioner’s secure website portal. As nice as that perfect world may be, the reality is that a host of disorganized self-employed individuals are filing Schedules C. Their recordkeeping may be jumbled at best. In fact, their records just may be kept in the dreaded shoebox. The topic of shoebox recordkeeping, which seems to be perfectly acceptable to many clients, just happens to be on the “A” list of Tax Season Survival Tips.

TAX SEASON SURVIVAL TIP: JUST SAY “NO” TO THE SHOEBOX!

Most practitioners have been on the receiving end of a client’s shoebox full of receipts, some of which are ripped, dirty, and some even smelling like cigarette smoke. The shoebox makes its way down the hall to the practitioner’s newest staff member (as if there is anything to learn from organizing a shoebox of receipts). This young staff member then sets out to organize the receipts, and spends valuable tax season time on the phone with the client asking questions like, “What was the business nature of the items you bought at Bed, Bath & Beyond on August 2?” This is a huge waste of time and talent. The staff member is not a better accountant when finished, and precious tax season time has slipped away performing unnecessary tasks. What can be done with the client who has saved his or her tax receipts in shoeboxes? When the client comes in for his or her tax season interview, would the following steps be a good idea for your firm?

1. Kindly hand the shoebox of receipts back to the client along with a very simple, easy to read—with bullet points—list of items that are tax deductible for businesses.

2. Inform the client that if he or she wishes your firm to organize the receipts, there will be an additional fee for this service on their invoice. (Be sure to state the amount of the fee, which should be commensurate with the size and organization of the shoebox. If it is a very large, disorganized shoebox containing everything from business expenses to charitable and medical receipts, the fee should be significant enough to cause a change in client behavior).

3. Tell the client that he or she can avoid the fee if he or she will organize the receipts and bring back an organized and categorized summation of the receipts.

The truth is, you were going to bill the client for the time spent with the shoebox anyway. BUT, you presented your client an opportunity to receive a discount on their fee if they would organize the shoebox. This action plan has solved the shoebox issue for many practitioners. Of course, there will always be clients who would rather pay the extra fee; however, this action will generally

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remove many shoeboxes from your office floor during tax season and reduce the number of hours your staff spends on these tedious tasks.

If a client does not have a good recordkeeping system, the tax practitioner should be instrumental in developing a good system for the client, which should include labeled files (paper or electronic) for receipts, credit card statements, sales records, invoices, purchase records, payroll records, bank statements and cancelled checks. The more organized the client, the more efficient the tax preparer. Additionally, if the client is audited, the client will easily be able to locate the source documentation required by the IRS.

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An excellent non-tax season service you can offer your clients is a training program about document requirements and organization. Clients who implement a good organizational system and apply it to their tax return documentation create valuable efficiencies for themselves and your tax practice.

Cash Intensive Businesses

Your new client, Johnnie, is self-employed and his very successful business is called, “Johnnie’s Honey-Dos.” He is in constant demand cleaning swimming pools, landscaping and maintaining yards, hanging Christmas lights, power-washing houses and driveways, performing minor repair work, painting, and other odd jobs. He is paid mostly in cash. He rarely deposits the cash and uses the cash to pay for his personal and business expenses. He does, however, keep a well-used spiral notebook in his car where he writes down the date he is paid, the customer who paid, and the amount paid. He also writes down business expenses when he incurs them but oftentimes throws out the receipts when he cleans his truck. He is an honest fellow and doesn’t cheat. But how can you convince him to keep better records?

A cash intensive business is a business that:

• receives a significant amount of receipts in cash and typically handles a high volume of small dollar transactions (e.g. restaurants, grocery stores), and/or

• practices cash payments for services (e.g. construction or trucking companies where independent contractors are generally paid in cash).

Client Tip

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The IRS, in its Announcement 2015-23, stated that it will no longer accept check payments for $100 million or more after January 1, 2016. Be sure and let all your clients know they can no longer write checks this large to the IRS!

IRS Red Flags

If you have a client who has a cash intensive business, sit up and take notice! The IRS does not take breaks from auditing cash intensive businesses. One of the most common issues of cash intensive businesses is underreporting income. The IRS uses different methods to determine whether income has been underreported.

What exactly is the IRS looking for when selecting cash intensive businesses to audit? The Cash Intensive Businesses ATG sets forth the frequent and unique issues or indicators, which raise red flags and trigger IRS attention. The most significant indicator is a pattern of losses or consistently low profit percentages that seem insufficient to sustain the business. Businesses that continue to operate for multiple years despite sustained losses or low profits is a red flag.

Other factors to consider when looking for underreported income include whether the taxpayer’s occupation is one which could have indirect sources of additional income (e.g. vending machines), and whether the income reported can support the size of the taxpayer’s family. The IRS also looks at whether the individual lives in a high value area that appears to be disproportionate to income reported, whether their itemized deductions such as property taxes and mortgage interest indicate that other property is owned that may not be commensurate with reported income, whether total deductions indicate expenditures greater than reported income, whether the taxpayer has income from investments, and whether there are any unusual deductions such as large gambling losses.

If you have a client in a mostly cash business who reports losses or low profits consistently on Schedule C, what can you look for when determining whether your client has reported all income? If there is reason to believe that income is underreported by our clients, we should take a closer look and consider the following:

• Does the client’s lifestyle seem to be consistent with the amount of income reported?

• Does the business continue to operate despite losses year after year?

• Do bank balances and other investments continue to grow even after reporting losses or low profits?

• Does the client continue to purchase assets even though losses or low profits are reported?

• Are debt balances decreasing in years that losses or low profits are reported?

• How does the client’s gross profit margin and annual sales align with other businesses in the same industry? (Statistics such as these can be found on the IRS website under taxpayer Statistics of Income (SOI) and at www.bizstats.com.)

Most tax preparers do not keep clients they don’t trust. But many clients, like Johnnie in the above example, are trustworthy. They are just disorganized. And if practitioners do not make proper inquiries and show due diligence, they could be assessed a nasty preparer penalty under Title 26 of the Internal Revenue Code.

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Another important reason to ask these questions is to determine if the client has an employee who may be embezzling. Cash intensive businesses should have sufficient internal controls in place that are enforced, including cameras installed in locations where employees are handling cash. But many small businesses do not rely on a system of internal controls.

Cases of embezzlement are interesting and shocking all at once. One case of great interest was the Collin Street Bakery in Corsicana, Texas. The Collin Street Bakery is famous worldwide for its DeLuxe fruitcakes, which have been purchased by Frank Sinatra, the queen of Spain, and my own mother, who used to ship a fruitcake to my grandmother in Florida every year for Christmas. One of the fruitcakes also made its way onto the set of the

“Godfather” movie. A small business turned big business through mail-orders of fruit cakes now has at least four locations, one of which sits on Interstate 45 in Corsicana, just south of Dallas. A delicious piece of pecan pie and a cup of hot coffee await many a weary traveler. The now ex-controller, a man given to excessive life style, worked for the bakery for years before he began embezzling. An accountant’s salary was just not enough to support the lifestyle this man and his wife wanted to live. Through years of embezzlement, the controller ultimately skimmed a mere $16 million from the bakery by fraudulent checks and an additional $114,000 from the petty cash fund.

The owners would look at their yearly financials, scratch their heads and wonder where the money was going.

But the bakery was building new locations and launching an aggressive Internet sales platform, so they chalked it up to expansion. At long last, as most embezzlement cases are discovered, the controller was caught red-handed by the new staff accountant who just couldn’t understand why certain transactions were recorded in an unusual manner. This fascinating story is available in an online article published by Texas Monthly entitled, “A Strange Tale of Fruitcakes and the Collin Street Bakery.” If you need a break from this course, for something much more interesting, go read this article.

The lifestyle of the controller screamed embezzlement, and if anyone had made appropriate inquiries and performed a financial ratio analysis of the financial statements, the inquiries and ratios themselves may have revealed the malfeasance. This story is a great lesson to practitioners - our clients also rely on us to report back to them things we find unusual. It might not be the owner skimming the cash; it might just be an employee.

So, our in-depth inquiries into our cash client’s affairs are not only our due diligence responsibilities, but also for our client’s protection.

Proper Accounting or Recordkeeping Procedures

What procedures should clients have in place if they have a cash-based business? This is certainly not a course on accounting procedures and internal control methods; however, there are many good courses available to help businesses develop detailed procedures. At the very least, a client should have a system that tracks every item of cash/income from the time it is received to the time it is deposited or spent. The basics:

• If a client uses cash registers, procedures should exist to ensure that the cash in the register drawers at the end of the day agree to cash sales recorded on the register, less the amount of money in the cash register drawer at the beginning of the day. A supervisor should make appropriate inquiries into any discrepancies. The cash register receipts should be kept with deposit slips to verify that all cash was deposited. Cash should be deposited regularly (preferably daily). There is always the risk that an individual

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pockets cash prior to ringing up the sale on the cash register. To reduce this risk, clients should require that a receipt be provided for every sale and, depending on the size and type of business, consider ways to incentivize the customer to ask for a receipt if they did not receive one (e.g. offer a discount or a free item if a receipt is not provided) as well as other controls.

• If a client does not use cash registers (like Johnnie’s Honey-Dos), the first thing the client should do is issue sequentially numbered invoices or receipts to each customer at the time of sale to document the cash received. At the end of the day, cash collected should agree to the total of these documents; all invoice/receipt numbers in the sequence should be accounted for. Cash should be deposited on a regular basis (preferably daily). The invoices or receipts should be kept with the deposit slips for proof that all cash collected was deposited. Of course, an individual could pocket cash if he or she is paid for a job that is not invoiced so the business would have to consider appropriate controls to limit and/or detect this activity (see above also). For instance, Johnnie from the example above could detect this if he keeps a record of all clients for whom he works in an appointment book or calendar showing bookings and agrees them to the invoices/receipts issued. An invoice should exist for all clients who are booked on the calendar, except for cancellations.

• In all cases, clients should have a working system of internal controls that includes procedures for receiving, reconciling, and depositing cash, including segregation of duties wherever possible. The paper trail generated by a working system of internal controls is excellent documentation in the event of an IRS audit.

Sometimes, small business clients who have inventory and are not audited yearly by independent CPAs, do not count physical inventory at year-end. Rather, they will give the tax practitioner a “guestimate”

rather than spending time taking an actual count. The problem with “guestimates” is that, year-after- year, the inventory number isn’t even close to materially correct and the cost of goods sold expense for the year is not accurate.

Practitioners can remind their less-than-diligent clients to take a physical count of inventory by sending out a reminder letter or email a month or two before the client’s year end (which is December 31 for businesses reported on Schedule C). This letter should explain the “why” of inventory counts. Oftentimes, just educating the client on the importance of physical inventory counts and accurate cost of goods sold numbers is enough to bring them into compliance.

The practitioner should also hold the client accountable for an inventory count. The client should have purchase and sales records that indicate what ending inventory should be and the inventory count should be reconciled back to these records; any significant differences should be explained.

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Making Use of the ATGs in Developing Tax Season Procedures

If a client falls within an industry for which an ATG is published, the practitioner should review the ATG for specific audit techniques related to that industry. Per the ATG, the IRS will request all bank statements, cancelled checks and deposit slips, along with all documentation supporting transactions.

An IRS examiner is also instructed to perform comparative analysis and ratio analysis of a taxpayer’s financial statements and other records to determine if any ratio is out of line with the average ratios within that taxpayer’s industry. The premise for comparative and ratio analysis is that when someone is misappropriating funds, or underreporting income, the ratios will reflect this imbalance. The examiner will compute ratios on gross profit margin, inventory turnover, ending inventory balances, changes in net sales from year to year, and changes in cost of sales from year to year, as applicable. The ratios will then be compared to businesses in similar industries. As stated in a previous section, statistics such as these can be found on the IRS website under taxpayer Statistics of Income (SOI) and at www.bizstats.com.

In searching for information about a taxpayer, the IRS may check with U.S. banks, credit unions, check cashing establishments, and currency exchanges to see if a Form 4789, Currency Transaction Report (CRT) was filed for the taxpayer. This form reports the deposit, withdrawal, and exchange of currency exceeding $10,000. The IRS may also check casino records, customs records, foreign bank account forms, criminal records, immigration files, loan application files, and asset locator databases. The examiner may search for any Forms 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, filed under a taxpayer’s name.

The IRS defines unidentified income (unreported income) as total cash expended exceeding total cash received.

To arrive at an amount of unreported income, the IRS employs different methods of reconstructing income. These methods are necessary when taxpayers do not keep complete and accurate records.

The Bank Deposit and Cash Expenditures Method of reconstructing income is one of the methods used by the IRS.

Agents will compare total bank deposits plus cash expenditures less nontaxable sources of income (gifts, loans, and transfers, etc.) for the year to total receipts reported on the return. Any excess of cash flow over the reported receipts is additional income or inflated expenses. The burden of proof is on the taxpayer to show that the IRS is incorrect in their reconstruction of income. Refer to the ATG for other methods the IRS uses to reconstruct income.

Regardless of the method used by the IRS to reconstruct income, the following questions, as listed in the ATG, may be asked:

• Did the taxpayer withdraw goods from inventory for personal use without making an adjustment to inventory?

• Did the taxpayer report the value of merchandise, trips or prizes earned from suppliers as income?

• How often does the taxpayer perform financial tasks (like reconciliations, deposits, bookkeeping, etc.)? If these tasks are not performed regularly, a greater opportunity exists to skim cash or make errors.

• Do employees get freebies from the taxpayer without any record?

• Is there a side-line business that is operated “off the books”?

• Did the client have any bartering transactions?

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• Did the client receive cash from other sources (family gift, loan, etc.)?

• Is there a stash of cash in a safe or other secure location? How was this cash received?

• What other sources of cash income are on site? This includes vending machines, newspaper stands, copy or fax machines, phone cards, etc. Is cash from these sources accounted for?

• What is the taxpayer’s system of internal controls and is it enforced?

• How did the taxpayer obtain the funds to make purchases?

• Did the client have a set of financial statements prepared to obtain financing or to sell the business? Are differences between these financial statements and the tax return explained?

• Are there angry family members or employees who claim mistreatment by the taxpayer?

• Are most expenses paid for by cash?

• How much petty cash does the taxpayer leave in the office or storefront?

• Is there any attempt by the taxpayer to delineate business and personal expenses?

• Can all loans of the taxpayer be verified?

• Was taxpayer paid in foreign currency?

• Is the taxpayer uncooperative, overly defensive, or aggressive toward the examiner?

• Does the taxpayer respond to inquiries in a timely manner?

• Does the taxpayer have sources of digital cash (EFTs, direct deposit, PayPal funds, bitcoin and other digital currencies)?

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If we know the IRS is going to ask these questions, wouldn’t it behoove us to ask our clients the same questions? These are reasonable inquiries to make when preparing financial statements and/or tax returns and should be included in our list of client service procedures.

The Cash Intensive Businesses ATG outlines specific examining procedures for the following cash intensive businesses:

Bail bonds Beauty shops Car washes

Check cashing locations Coin operated amusements Convenience stores

Laundromats Scrap Metal Taxicabs

Retail liquor industry Video games Pizza pie sales

New auto dealerships Used auto dealerships Gasoline service stations

Auto body repair Retail gift shops Restaurants

Bars Grocery stores Boat and yacht sales

*If a tax practitioner has clients in these cash intensive businesses, he or she should review the IRS examination procedures in the ATG and make every effort to answer the questions listed above. Then, document, document, document in the client file the answers to the questions. And if the client does not have an acceptable answer to a question, then steps should be taken to ensure the client is following reasonable practices with respect to its cash.

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ALERT

Please note that if the IRS discovers underreported income and finds sufficient evidence the client intentionally understated income, the IRS will pursue civil or criminal fraud charges against the taxpayer, and sometimes the practitioner as well. Fraud is defined as:

• Misrepresentation of material facts,

• Deception, which is the intent to conceal records, cheat, or mislead the examiner, and

• Silence when good faith requires expression.

According to the IRS, the underground economy represents income that is earned under the table and off the books, which can be generated by legal and illegal activities. The primary goal of those involved is to avoid reporting income and paying taxes. As practitioners, it goes without saying that we should not engage clients who have businesses in the underground economy, especially those involved in illegal activities such as black market goods, drug sales, money laundering and warehouse banking schemes. The ethics requirements for maintaining a CPA license were enacted because a small number of CPAs were engaged in unethical and/or illegal behavior. It just makes good sense to avoid clients in shady businesses.

The following business activities listed in the ATG are considered by the IRS as possible opportunities for underground activities:

Used car sales Child care House cleaning

Pet sitting Tree trimming and hauling Construction workers

These seem to be rather innocuous professions; nevertheless, the IRS views them dimly. I hate to tell my son this because he operated a pet sitting business from third to eighth grade. Such a young age to be on the shady side of life.

Reporting Cash Payments Received Exceeding $10,000

In this discussion of cash intensive businesses, we should review the requirements of Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business. If our clients receive $10,000 in cash from one buyer in a single transaction, or two or more transactions that are related, this form must be filed with the IRS.

Form 8300 provides information to the IRS and the Financial Crimes Enforcement Network (FinCEN) for use in busting money launderers. Information filed on this form has been used to identify tax evaders, drug sellers, and terrorists.

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The filer of the Form 8300 should mark Box 1b on the top line of the form if the transaction is “suspicious”, defined as:

• The payer of the $10,000 is trying to prevent the business from filing Form 8300,

• The payer of the $10,000 is trying to cause the business to file a false or incomplete Form 8300, or

• There is indication of possible illegal activity.

The form is due by the 15^th day after the date the cash transaction occurs. The form can be filed either electronically or mailed.

Our clients must also furnish a written statement to each buyer (the person who pays the cash) for whom a Form 8300 was filed. The statement must include:

• the name, address, contact person, and telephone number of the business filing Form 8300,

• the aggregate amount of cash the business reported to the IRS,

• and notification that the business reported this information to the IRS.

The IRS assesses criminal and civil penalties for failing to file Form 8300 and the requisite statement to the buyer. The penalty for failure to file a timely and correct Form 8300, and the penalty for failure to furnish a written statement to the buyer, is $280 per instance. If the failure is corrected on or before 30 days after the required filing date, the penalty is $50 per instance. Annual maximums also apply and are determined based on whether average annual gross receipts are greater than $5 million.

If the IRS determines that there is an intentional disregard to file a timely and correct Form 8300, the penalty is the greater of $28,260 (numbers provided are for returns filed in 2021; amount is adjusted annually for inflation) or the amount of cash received in such transaction—not to exceed $113,000. If there is intentional disregard of furnishing a statement to the buyer, the penalty is the greater of $560 per statement or 10% of the aggregate amount of the items to be reported correctly.

For more information, see “Form 8300 and Reporting Cash Payments of Over $10,000” at www.irs.gov.

If an owner of a cash intensive business is hiding something, he or she will usually move on when the tax practitioner begins to make in-depth inquiries. Here are two examples from real life:

1. A practitioner was preparing the financial statements for a new restaurant client who was using Point of Sale software. The practitioner noticed that daily deposit slips never agreed to the cash recorded by the POS system. When the practitioner made inquiries, the owner of the restaurant readily admitted that he always took cash from the register for his personal needs. The practitioner then informed the owner that she was going to include the cumulative difference between the daily deposits and the POS recorded cash on a Form W-2 for the owner and have him pay payroll taxes on that amount. At that point, the client informed the practitioner that he would take his business elsewhere (much to the relief of the

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practitioner). Not long after, the restaurant closed, the owner moved to another state and filed bankruptcy.

2. Another practitioner was preparing financial statements and the tax return for a new pawn shop/payday lender client who had huge reserves of cash in a safe in the back of the store. The client had impeccable records with respect to his pawn sales, eBay sales, and loans outstanding and repayments. However, the practitioner could never reconcile the cash in the vault to the client’s records. When the practitioner made inquiries, the client—without hesitation—fired the practitioner and moved on to another accountant who did not make such inquiries.

TIP

As practitioners, we should be very wary of clients who regularly change accountants. We should always ask during the initial client interview, “Why are you changing from your prior accountant?” Listen very carefully to the answer. If they are too quick to blame the former accountant, you may want to send them on down the road to another practitioner.

Summary and Action Plan

All taxpayers are required by law to maintain sufficiently-detailed records for the proper preparation of a tax return. The IRS states in the Cash Intensive Businesses ATG that “poor books and records indicate reduced credibility.” I believe that tax practitioners would agree with the IRS on this matter. Our experience generally finds that the clients with the worst records are the worst clients.

In designing procedures for servicing cash-intensive business clients, practitioners should include inquiries into their system of:

1. Accounting for all cash (and all income payments) from the time received to the time either deposited or spent.

2. Accounting for all expenditures.

3. Internal controls, and whether the internal control actions are carried out by the employer and staff.

4. Organizing and compiling records for the preparation of financial statements and tax returns.

In developing these procedures, we should regularly review the ATGs with respect to our clients’ industries—not so that we can become the auditor—but so that we can be prepared for an audit should it ever occur. Making these inquiries of our clients protects us from due diligence preparer penalties, identifies possible embezzlement, and serves as a system of weeding out potential clients who try to cheat the system.

Finally, for those clients who are just disorganized, practitioners should offer as an additional service a system to help them become organized. This service could be in the form of online training or an evening class, possibly preceded by a meal or social hour, that could be offered to clients as well as members of the community.

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Review Questions - Section 1

1. Information that is excluded from an Audit Techniques Guide is:

A. Financial statistics pertaining to a specific industry.

B. A listing of all Internal Revenue Codes and judicial precedents related to a specific issue or industry.

C. A listing of questions an IRS examiner will ask a taxpayer upon audit.

D. Accounting methods unique to a specific industry.

2. Per the Cash Intensive Businesses ATG, which is the most significant indicator of possible underreported income?

A. Taxpayer continues to purchase assets despite reporting consistent losses.

B. The taxpayer’s bank balances continue to grow even after reporting consistent losses.

C. The lifestyle of the taxpayer is inconsistent with the income reported on his or her tax return.

D. A pattern of losses or consistently low profit percentages.

3. Which cash intensive business is also a potential opportunity for underground activities per the Cash Intensive Businesses ATG?

A. Used car sales B. Bail bonds C. Pizza pie sales

D. Check cashing locations

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Section 2:

Hobby Loss Rules

Learning Objectives:

After completing this section, you should be able to:

1. Recognize red flags on an individual tax return which can potentially alert the IRS to a hobby loss issue.

2. Recognize how to report hobby income and expenses on an individual income tax return.

3. Identify certain activities the IRS views as potential hobbies of taxpayers.

4. Identify an IRS-proof profit motive using the nine factors listed in Reg. §183-2(b).

5. Recognize when and how to make an IRC 183(e) election.

Is This Activity a Hobby?

As practitioners, we’ve probably all seen something like this: Steve Wakeboard is a very likeable fellow. He is employed full-time as a manager of a retailer that sells outdoor and recreational clothing and supplies. He loves all water sports: sailing, skiing, surfing, and scuba diving. On the weekends during the summers, he earns extra income by using his boat to take individuals out in the bay to teach them how to scuba dive. He wants to write off his boat, his scuba equipment, his lunches at the marina, even his swimsuits. While Steve may be living the dream, we are left with the decision of whether his scuba instructing is a business or a hobby.

Resources for Further Study

• IRS Fact Sheet, “Is Your Hobby a For-Profit Endeavor?” at FS-2008-23, June 2008.

• Audit Technique Guide - IRC § 183: Activities Not Engaged in For Profit.

A wise tax practitioner should be well versed on how the IRS views the profit motive issue. The IRS Fact Sheet and the ATG are excellent resources to study to gain insight into the IRS’s views.

Caution: Since this ATG was published in 2010, it has not been updated for various tax law changes enacted since then, including those made by the Tax Cuts and Jobs Act of 2017 (TCJA) which impacted the

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deductibility of hobby expenses. Practitioners and business owners need to be diligent when using the ATGs to ensure they are applying the current law to their issues and circumstances.

Hobby vs. Business: What’s the Big Deal?

Well, it is generally only a big deal if an activity incurs losses year after year. A Schedule C that reflects net income every year is not likely to be in danger of being reclassified as a hobby. Net income on a Schedule C is subject to self-employment tax while hobby income is not subject to self-employment tax. The IRS likes net income on a Schedule C for the obvious reason that a higher tax liability is generated.

Income Subject to Self-Employment Tax

IRC §1401 imposes a self-employment tax on net earnings from self-employment. The definition of self- employment income is provided in IRC §1401 as “gross income derived by an individual from any trade or business carried on by such individual”. Gross income is reduced by allowable deductions to arrive at earnings from self-employment which are entered on Schedule SE, Self-Employment Tax. (Refer to Schedule SE and its instructions for details of the tax calculation.) Additionally, taxpayers are generally allowed a deduction equal to one half of the self-employment tax which is reported on Schedule 1 (Form 1040) (2019 form reference).

The IRS defines a trade or business as an activity carried on for the livelihood or in good faith to make a profit, hence the term profit motive. Additional rulings have defined a trade or business as one that is regular, frequent, and continuous.

Income from the following activities is not subject to self-employment tax:

• Investments

• Hobbies

• Employment

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But what about activities incurring losses?

Exhibit 1. Governing Provisions of the Internal Revenue Code.

If the activity is…* Then…

A business. • Expenses are deductible under IRC §162.

Engaged in for the production or collection of income or for the management, conservation or maintenance of property held for the production of income.

• Expenses are deductible under IRC §212.

A hobby (activity not engaged in for profit). • Treatment of expenses determined by IRC

§183.

A personal activity. • Per IRC §262, no expenses are deductible.

*Taxpayers bear the burden of proving their honest intention of making a profit.

The Treasury Inspector General for Tax Administration (TIGTA) issued a report on April 12, 2016, Reference Number 2016-30-031, “Opportunities Exist to Identify and Examine Individual Taxpayers Who Deduct Potential Hobby Losses to Offset Other Income.” TIGTA performed a review of the IRS’s success in auditing tax returns for the hobby loss issues, and found that the “IRS can improve its methods of addressing taxpayers who offset their income with hobby losses,” and recommends that the IRS 1) identify high-income individual returns with multi- year Schedule C losses and other factors that indicate the taxpayer may not have a profit motive, and 2) emphasize the importance of ensuring that hobby loss issues are pursued in an examination of a return. A bit alarming is the fact that TIGTA also reported that it considers 88% of Schedule C losses as hobby losses! With that statistic, we must take special efforts to ensure that our clients have legitimate profit motives for all of the Schedules C filed.

When an Activity Is Truly a Hobby

If the taxpayer’s facts and circumstances point undeniably to the fact that an activity is a hobby, then IRC §183 (the “hobby loss” rule) determines the treatment of expenses. Expenses related to a hobby cannot exceed income received from the hobby. The income is reflected as other income on Form 1040 and is not subject to self- employment tax. For 2019, hobby income was reported on line 8, Other income, of Schedule 1 (Form 1040) where it was combined with additional income items. The total of all additional income from line 9 of Schedule 1 was

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brought forward and reported on line 7a, Other income on Form 1040, If the hobby income is from the sale of collectibles, the sales should be entered on Form 8949, Sales and Other Dispositions of Capital Assets.

Prior to the TCJA, expenses related to a hobby were deducted on Form 1040, Schedule A, Itemized Deductions, in the following order:

1. Deduct expenses that are allowed regardless of the taxpayer’s profit motive related to the hobby, for example home mortgage interest, taxes and casualty losses.

2. To the extent hobby income exceeds the items number 1, deduct expenses that would be allowed if the activity was engaged in for profit (other than depreciation and amortization) as miscellaneous itemized deductions on Schedule A.

3. To the extent hobby income exceeds expenses listed in points 1 and 2, depreciation and amortization can be deducted, limited to the amount of the remaining hobby income, as miscellaneous itemized deductions on Schedule A.

The TCJA suspended miscellaneous itemized deductions from 2018 through 2025 which means hobby losses are generally not deductible during this time period.

Practically speaking, very few taxpayers will cede that their activity is a hobby, unless there are no expenses to offset the income.

When there are expenses, most taxpayers will receive greater benefit by reflecting an activity’s income and expenses on a Schedule C rather than treating it as a hobby because:

• Taxpayers who take the standard deduction will receive no benefit from hobby expenses on a Schedule A.

• Taxpayers who itemize will likely receive no benefit from the activity’s expenses due to the 2% limitation on miscellaneous itemized deductions, or to the overall limitation on itemized deductions for high income taxpayers. (Note: TCJA suspended all miscellaneous itemized deductions and the overall itemized deduction limitation from 2018-2025.)

Additionally, if the expenses exceed the income reported on Schedule C, the loss can be used to offset other income (wages, interest, dividends, etc.) shown on the Form 1040.

A quick reminder that the IRS is less concerned when income is consistently reported from a hobby or Schedule C activity than it is when a Schedule C reflects losses on a consistent basis. So, if you have clients who have been reporting losses on a regular basis on their Schedule Cs, sit up and take notice! If you know what the IRS is looking for in establishing a profit motive for an activity, you will want to have a discussion with your client about how to survive a potential IRS audit.

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Building an IRS-Proof Profit Motive

As stated in Section 1, the ATGs are one of the best resources for determining how the IRS views certain issues.

The ATG for the IRC §183 “hobby loss” rules instructs examiners to consider the following items on a tax return:

• Activities with large expenses and little or no income.

• Losses offsetting other income on the return.

• Activities that result in a large tax benefit to the taxpayer.

After identifying target activities, an examiner will study the history of the activity to determine whether it has shown a profit in any year. The examiner will use taxpayer’s financial history, documentation of the activity operations, and any accounting records.

PRACTICE TIP

Since we practitioners have this information available in IRC §183 ATG, we should apply it while reviewing our clients’ files and prepare every future tax return as if it were to be audited by the IRS within the next three years. This will help identify and resolve potential issues with our clients and ensure that our work papers and our client’s documentation and accounting records adequately address the questions and issues IRS examiners are likely to raise.

The IRS then applies nine relevant factors, set forth in IRC Reg. §183-2(b), to determine whether the taxpayer has a profit motive. This determination is made on a case by case basis, considering all facts and circumstances of the case. For further study, an excellent discussion of these nine factors is found in Appendix A of the Audit Techniques Guide for IRC §183: Activities Not Engaged in For Profit. Appendix B of the same ATG lists questions the IRS Examiner will ask when auditing whether a profit motive exists. A quick read of these questions is a valuable use of time.

ALERT!

The ATG lists the following activities as possible hobbies. If you have a client engaged in an activity listed (and we all do), sit up and take notice! A little planning on this side of an audit will surely assist your client in establishing his or her business purpose for the activity.

Fishing Horse Racing Horse Breeding

Farming Motorcross Racing Auto Racing

Craft Sales Bowling Stamp Collecting

Dog Breeding Yacht Charter Artists

Gambling Photography Writing

Direct Sales Airplane Charter Rentals

Entertainers

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The following checklist serves to alert you, the practitioner, to the nine relevant factors of establishing a profit motive. From this list, you should be able to identify problems that may exist with certain client activities, and the actions and documentation needed to support the client’s profit motive. At a minimum, you should consider retaining this documentation in the client’s work papers to ensure it is available if and when an IRS examiner requests it.

Reg. §183-2(b) Nine Factors

Evidence of Motive

1. Manner in which the taxpayer carries on the activity.

Does the taxpayer:

• carry on the activity in a businesslike manner?

• maintain complete and accurate books and records?

• maintain checking accounts for the activity which are separate from the accounts used for the taxpayer’s personal living expenses?

• rely upon these records to operate the activity and make decisions or changes?

• have a formal written business plan which demonstrates the taxpayer’s financial and economic forecast for the activity by showing a short range and long range forecast for the activity?

• follow the business plan?

The IRS examiner will:

• document the taxpayer’s daily operations, the history of the activity’s operations, and the efficiency of the taxpayer’s operations.

• obtain copies of any advertising.

• be alert for children’s activities being deducted on the parent’s tax return.

2. The expertise of the taxpayer or his advisors.

Has the taxpayer:

• prepared for the activity by extensive study of its accepted business, economic, and scientific practices?

• consulted with those who are experts in the business?

• question the taxpayer’s expertise and the use of any experts in the business.

• compile the history of the taxpayer’s growth of knowledge within the activity and how this knowledge was obtained.

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• document the names, position titles and address of advisors and how they were chosen by the taxpayer.

• document instances when the taxpayer was provided advice that was implemented in the activity.

• describe how this information affected the operation.

3. The time and effort expended by the taxpayer in carrying on the activity.

• devote much of his or her personal time and effort to carrying on the activity? (including time spent for seminars, professional reading, and performing repairs and maintenance.)

• derive substantial personal or recreational aspects from the activity?

• withdraw from another occupation to devote much of his or her energies to the activity?

• establish precisely how much time the taxpayer devotes to this activity, as well as all other activities.

• consider whether the provisions of Sec 469 (passive activities) apply to the taxpayer.

4. Expectation that assets used in the activity might appreciate in value.

*This has been the most difficult of the factors for examiners to correctly develop.

• use appreciated assets, such as land, in the activity?

• expect the appreciation in the value of the assets, even if no profit from current operations is derived?

• expect that income from the activity together with the appreciation of the assets will exceed expenses of operation?

*ALERT!: The success of Factor 4 is dependent upon whether the operation of the taxpayer’s activity and the holding of appreciated assets, like land, are considered to be a separate or single activity. If deemed separate activities, taxpayers will often not meet this factor, and the potential gain from appreciation of the assets will not be considered for overall profit and cannot offset current operational losses.

*Warning to taxpayers using land purchased for future retirement purposes in an activity: Because the Tax Court has ruled for both the IRS and taxpayers in separate cases, it is wise to review the facts of these cases to determine how to properly structure the activity’s use of retirement land in such a way that the land will be included as part of the activity.

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5. The success of the taxpayer in carrying on other similar or

dissimilar activities.

Has the taxpayer:

• engaged in similar other activities that were unprofitable and converted them to profitable?

• document the taxpayer’s financial success in other activities.

• prepare a worksheet that details the history of these other activities.

• document any specific instances where the taxpayer has abandoned certain activities proven to be unsuccessful.

Note.

The IRS does not take into account the success of the taxpayer in his or her salaried job when considering the success of the taxpayer in other similar or dissimilar activities.

6. The taxpayer’s history of income or losses with respect to the activity.

*According to the ATG, this factor is one of the most important factors of the nine. This factor supports the framework of IRC §183 because the history of losses triggers the question of profit motive.

Does the taxpayer have:

• sustained losses beyond the period which customarily is necessary to bring the operation to profitable status?

• an explanation for why there are sustained losses?

• prepare a worksheet showing a history of the activity’s profits and losses.

Reasons for losses that are beyond the taxpayer’s control and would not indicate the lack of a profit motive as listed in the ATG:

drought, disease, theft, fire, weather damages, involuntary conversions, or depressed market conditions.

7. The amount of occasional profits, if any, which are earned.

What are the taxpayer’s:

• amounts of profits in relation to the amount of losses incurred, in relation to the amount of the taxpayer’s investment and the value of the assets used in the activity?

• amounts of substantial occasional profits, if any?

Small Business: Avoiding Problems with the IRS

Small Business:

Avoiding Problems with the IRS

Small Business:

Avoiding Problems with the IRS

©

Course Description

Table of Contents

Section 1:

Recordkeeping and Cash Intensive Businesses

Learning Objectives:

Overview

Audit Techniques Guides

Careful Recordkeeping

1. Proof of income upon audit.

2. IRS matching.

3. Documentation of all business expenses.

Cash Intensive Businesses

IRS Red Flags

Proper Accounting or Recordkeeping Procedures

Making Use of the ATGs in Developing Tax Season Procedures

Summary and Action Plan

Review Questions - Section 1

Section 2:

Hobby Loss Rules

Learning Objectives:

Is This Activity a Hobby?

Hobby vs. Business: What’s the Big Deal?

When an Activity Is Truly a Hobby

Building an IRS-Proof Profit Motive