John and Marcella McCormack v. Commissioner, Docket No. 25758-11S, filed in February 11, 2013 is a good example of how taxpayers lose tax deductions and are assessed penalties by the IRS. The couple showed $5,360 of receipts on their Sch. C. home renovation business and reported a loss of $41,818. The majority of the business expenses related to them claiming 100% of the costs associated with their Mercedes 450 GL automobile which they claimed was used exclusively for business purposes. In addition to the home renovation business, they claimed that Marcella used the car for work related to her W-2 employer for which she was not reimbursed. When asked to provide evidence that the employer required the use of her personal automobile, none could be produced and the evidence showed that the employer provided company vehicles to it employees when on company business. When asked by the IRS to produce a mileage log to substantiate the business mileage for the home renovation business, no log could be produced. The couple eventually admitted that the Mercedes was also used for personal, family and household purposes, and the taxpayer lost its auto depreciation deduction because they could not substantiate that the business use was greater than 50%.
The McCormacks, residents in CA, also owned a rental property located in GA that generated $4,200 in gross rents and claimed a net loss of $20,552. Even though they use a property manager, the McCormacks took the position that they actively managed the rental property and were therefore entitled to deduct the entire loss. The IRS disputed that they actively participated in the rental. However, regardless of whether the rental property was actively managed or not, the rental loss begins to phase out when the taxpayer’s adjusted income reaches $100,000 and is entirely lost when AGI reaches $150,000. Since the McCormack’s AGI was greater than $150,000, they were not entitled to any rental loss deduction.
To “reward” the McCormacks for their tax return positions that lacked substantiation, the IRS assessed them an accuracy-related penalty which is 20% of the tax assessment. The penalty is not assessed if the taxpayer acted with reasonable cause and in good faith . . . the argument made by the McCormacks . . . saying that they relied upon their accountant to prepare an accurate return. The IRS prevailed with its penalty assessment arguing that the accountant relied upon representations made by the taxpayer, not the other way around.
What can be learned from this case? First, maintain a contemporaneous mileage log book showing the date of the travel, the business purpose, and the mileage. Second, maintain a contemporaneous real estate log book showing the date of participation, the rental mmanagement activity performed, and the time spent on the activity. Third, work with an experienced tax professional who understands the tax laws and who can advise you when you run afoul of the tax laws.
Note: Because each person has unique needs and because tax laws are subject to change without notice, we invite you to call 610-594-2601 today to make an appointment to discuss your personal tax situation.
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