With summer well underway and tax season behind us, we thought it would be a good idea to alert you to the fact we are seeing an increase in IRS audits for all types of entities, including the following:
• Individual returns
• Partnership returns
• C corporation returns
• S corporation returns
The IRS is focusing on certain areas as well. These include hobby losses for schedule C filers, charitable contributions, meals and entertainment expenses, and passive activity v. active trade or business.
In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business. An activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit. The IRS has always scrutinized taxpayers’ side ventures and presumes that an activity is carried on for profit if it made a profit during at least three of the last five tax years, including the current year.
If you file Schedule C and have reported losses for the last few years, please be aware that you may be an IRS target.
Two recent IRS decisions stress the importance of meeting the strict substantiation requirements for claiming charitable contribution deductions. David Durden, TC Memo 2012-140, highlights this fact.
In this recent case, Mr. and Mrs. Durden donated around $22,000 to their church during tax year 2007. The donations were made by check and the Durdens produced copies of the cancelled checks upon audit. The IRS disallowed the deduction because the written acknowledgement from the church failed to contain certain language required by law. In order to be deductible, the tax court held that the following factors must be present on the acknowledgement:
1. The name and address of the charity
2. Date of the contribution
3. Amount of cash or a description of any property contributed, and
4. A list of any significant goods or services received in return for the donation or language in the acknowledgement that expressly states the donor received no goods or services from the charity.
Note that the above documentation must be in the taxpayers’ possession by the time the tax return is filed. Because the taxpayers’ receipt from their church did not contain the required statement regarding whether goods or services were provided, the deduction was disallowed. Moreover, the IRS disallowed a corrected letter from the Durdens’ church because the revised acknowledgement was received after their 2007 tax return was filed.
Therefore, the IRS does not have to look any further than the written acknowledgement. If the acknowledgement fails to provide the required information, the deduction will most likely be denied.
In Joseph Mohamed, Sr., TC Memo 2012-152, the Mohameds lost charitable contribution deductions of over $18 million because they did not follow the strict requirements for substantiating noncash donations over $5,000. Mr. Mohamed, a real estate broker and certified appraiser, donated six properties worth at least $18.5 million to a charitable remainder trust in 2003 and 2004. Upon audit, the IRS disallowed the deduction for two reasons:
1. The taxpayer’s self appraisal of the properties was not a qualified appraisal. Although Mr. Mohamed is a certified appraiser, the tax laws provide that a qualified appraiser cannot be the donor or taxpayer claiming the deduction or the donee of the property.
2. Furthermore, the Mohameds failed to attach to their 2003 and 2004 tax returns an appraisal summary.
Many of us find this case troubling because the real estate in question was subsequently sold for an amount in excess of the deduction claimed. So the disallowance of the deduction in this case had less to do with the fact of the value of the donation than with the taxpayer’s technical compliance with the law concerning its substantiation.
Both of these cases point out the imperative importance of complying with the rules for substantiating a charitable contribution.
Meals and Entertainment Expenses
In order to take a tax deduction for meals and entertainment expenses, the tax code requires that the expense be substantiated as follows:
1. The amount of expense (including receipts)
2. The time and place of expense
3. The business purpose of the expense and
4. The business relationship to the taxpayer of the individuals being entertained, including the names and titles of the people being entertained.
In order to be deductible, the business purpose of the expense or the business benefit gained or expected to be gained must be documented. The receipt must be accompanied by a statement that says the entertainment expense had a bona fide business discussion that went along with the deduction and that you had “more than a general expectation” of gaining a business benefit from the entertainment.
During audits, IRS agents have been very strict in enforcing these substantiation requirements. If you are audited and do not have a log or account book to substantiate these expenses, they may be disallowed.
Passive v. Active Trade or Business
Another area on which we are seeing agents focus is taxpayer activities where we conclude they are active, but the agents think they are passive. As a rule, losses generated by passive activities can only be used to offset income generated by passive activities. There are two kinds of passive activities – rentals and businesses in which the taxpayer does not materially participate. The latter includes activities on Schedules C and F and from partnerships, S corporations and LLCs.
There are different participation requirements required under business activities and rental activities and agents are routinely requesting backup for active participation. Therefore, if you have rental activities, for example, and have a loss during the year, in order to offset ordinary income with the rental loss, you must be able to prove active participation to the IRS. Likewise, if you receive form K-1 from a partnership in which you are a member, in order to deduct the losses against ordinary income, you must prove that you materially participate in the business.
The IRS has determined that an individual materially participates in business activities if he or she participates on a “regular, continuous and substantial basis.” Some of the factors that the IRS uses to determine material participation include the taxpayer working 500 hours or more during the year in the activity, does the taxpayer do substantially all of the work in the activity, and has the taxpayer materially participated in the activity in any 5 of the prior 10 years.
In conclusion, the number of IRS audits appears to be increasing and the agents are being very assertive in applying the tax law. If you have additional questions about substantiation requirements or deductions in general, please contact your Clark Schaefer Hackett representative.