“Tax Specialist” Fails to Sustain Schedule C Deductions When Audited by the IRS
Background
A married couple (H. Samadi, TC Summary Opinion 2018-27) included a Schedule C on their personal income tax return which reflected the husband’s translation services, real estate activity, and tax preparation services. The Schedule C reflected a loss which was used to offset other sources of income.
The husband self-prepared their joint income tax returns identifying his occupation as a “tax specialist” and his wife as a register nurse.
The husband was part of a group of five friends and family that intended to buy homes, renovate them, and sell them for a profit (house flipping). He was a licensed real estate agent who had access to properties that were for sale. The investment group had decided that Samadi would manage the properties purchased.
Samadi prepared mileage logs to document the mileage he drove to see the potential investment properties. He relied on IRS Pub. 463, Travel, Entertainment, Gift, and Car Expenses, in preparing these mileage logs. He maintained a daily spreadsheet on his computer for each year’s mileage log. He input the starting and ending addresses, beginning and ending mileage, miles traveled, and business purpose of each trip. According to the mileage logs, he drove 24,882 miles in 2013 and 25,220 miles in 2014.
IRS Findings
The mileage book reflected that the taxpayer made two round-trips on Saturdays. He drove almost 190 miles to pick up his “client”, drove back the same distance to show a potential investment property to his “client” (near his personal residence), drove 190 miles to return his “client” back to their home, and then returned to his residence. His “client” was his brother-in-law or another member of the investment group. The group did not buy any investment properties in the years audited. During these tax years, Samadi did not earn any real estate commissions.
Business deductions are allowed for ordinary and necessary expenses in the course of a trade or business.
The IRS denied the real estate deductions on Schedule C because the taxpayer could not provide any evidence to suggest that he was continuously and regularly buying and selling real estate as a real estate agent to clients. At best, the IRS found that the husband’s activities were in the exploratory or formative stages of forming a business of flipping houses and that the business had yet to commence.
In addition to assessing taxes for the denied tax deductions, the IRS assessed accuracy-related penalties because the Samadi’s had not acted reasonably and in good faith with respect to the substantial understatement of income tax. The taxpayers were unable to explain which IRS publications or other authority they consulted to determine whether the husband was carrying on a trade or business. Further, the husband held himself out to be a tax specialist and prepared tax returns as a business. Therefore, he should have been able to consult the tax law or regulations to determine whether he was carrying on a trade or business.
Tax Law Overview
Generally, the IRS’s determination of a deficiency is presumed correct, and a taxpayer bears the burden of proving it incorrect. In addition, deductions are a matter of legislative grace and the taxpayer bears the burden of proving entitlement to any deduction claimed.
If the taxpayer produces credible evidence with respect to any relevant factual issue and meets other requirements, the burden of proof may shift to the IRS.
IRC Sec. 162(a) provides that “there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business”. The courts have found that “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and . . . the taxpayer’s primary purpose for engaging in the activity must be for income or profit.”
Furthermore, Sec. 162 does not permit current deductions for startup or pre-opening expenses incurred by a taxpayer before beginning business operations. {See IRC Sec. 195(a) for possible relief}
Court’s Findings
The Tax Court decided in favor of the IRS that the taxpayer was not engaged in a trade or business related to his real estate activities. It found that the taxpayer had not provided any credible evidence that he was engaged in a trade or business and thus the burden of proof had not been shifted to the IRS. The court state that looking at investment properties did not rise to the level of being engaged in a trade or business.
Since the taxpayer was found not have been engaged in a trade or business, the veracity of the mileage logbook was not determined as the taxpayer was not allowed any Sch. C deductions related to his real estate activities.
The court satisfied itself that the IRS’s 20% accuracy-related penalty attributable to a substantial understatement of income or to negligence or disregard of rules and regulations had been properly approved by the IRS. The burden is then on the taxpayer to come forward with persuasive evidence to show he acted with reasonable cause and in good faith with respect to the underpayment of tax.
The court took note of the fact that the taxpayer held himself out as a “tax specialist” and was unable to provide any evidence that he researched the tax law or IRS regulations regarding what constitutes a trade or business. In fact, the taxpayer testified that he did not see a purpose for referring to any regulations in preparing their joint income tax return.
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About F. Bryan Haarlander, EA, CTRS:
Bryan Haarlander is an IRS licensed Enrolled Agent and who owns and operates a specialized tax services firm serving clients in the western suburbs of Philadelphia, PA, which includes the cities of Chester Springs, Coatesville, Collegeville, Devon, Downingtown, Exton, Frazer, King of Prussia, Paoli, Philadelphia, Phoenixville, Pottstown, Radnor, Reading, Wayne, West Chester in Berks, Chester, Delaware, Montgomery and Philadelphia Counties, as well as clients in Delaware, New Jersey, New York and throughout the continental USA.
A Certified Tax Resolution Specialist, Bryan is well-known for his IRS tax resolution expertise and his book How to Resolve Your IRS Tax Debt Problems.
