Help with audit clarification

[rfk]

I was involved on my very first audit and was surprised to see certain info regarding examination changes (tax payer essentially has no real backup for items entered on tax return; TurboTax prepared)

How does the adjustment to income work? Can someone help me with how the IRS works this form?

Adjustments to income for this client (Denied):

Conference expenses (Schedule C) 11,500
Travel & Meals (mostly travel, Schedule C) 11,400
Comm. & Fees (this person is an Ed Consultant) 8,530
Write down Car & Truck expense – small % allowed 21,304

So essentially the IRS auditor is imputing SE Income of $52,734

How are adjustments normally computed to derive a number for calculating the correct tax? In this instance, the adjustments are more than the gross receipts for the Schedule C!

In the meantime, I am asking my client to look “again” at properly gathering all the documentation for her expenses so I can go to bat for her. She just did not provide proper documentation and now the IRS is beating her up with penalties and interest.

Thank you for your thoughts regarding Form 4549; but I think it I am seeing this all wrong in its content.

rfk

[erchess]

Cold Facts

In an audit of Schedule C expenses the taxpayer must prove two things: that the expenses were each paid and that each was "ordinary and necessary" considering all the facts and circumstances. Your client appears not to have the records to meet the first part of her burden and the auditor I think is saying that the second part doesn't come up.

There is one sort of exception to that but you will need to do some research because a bulletin board is not a place where I can tell you everything you must understand in order to use the exception. Under the Cohan Rule some numbers favorable to the taxpayer may be inferred but only at the least helpful to the taxpayer values that are at all believable. It is necessary to explain why records are lacking and foolish behavior by the taxpayer is not enough. On the other hand if records once existed but were stolen or destroyed in say a fire or flood, you have a chance. Another problem with Cohan is that certain types of expenses including mileage and charitable contributions are by statute exempt from the Cohan Rule and for these there is no deduction without substantiation period. Another fact that must be faced is that sometimes the courts seem to capriciously ignore Cohan. But the very limited tool of Cohan is about all you have going for you when your client can't produce canceled checks, credit card statements, invoices marked paid, or sales receipts to prove that the expenditures were made. I note again that even under Cohan there has to be a reasonable explanation for why the present non existence of records is due to circumstances beyond the taxpayer's control.

[luke]

what bothers me

is that I THINK you are saying that auditor adjusted income to be MORE than the sch C income as originally reported? I would have to argue THAT! If they want to take expenses down to zero thats one thing but income should be an easily proved item? Good luck!

[Jiggers]

Was there a loss on C?

What was the loss on C before the IRS made the $52,734 adjustment?

I assume there was a loss.

Adding the $52,734 back to the loss, just reduces the loss, and may even have a profit.

But the full $52,734 should not be subject to SE tax.

And I would really earn my EA status and FEE and work with the client to prove these expenses, or a portion of them. Even if I had to go to appeals.

[JohnH]

Is it possible that there were multiple 1099 forms which added up to more than the gross receipts originally reported on the Sched C? Or were there cash receipts reported & detailed in some manner, and then the audtor added 1099 totals to that figure? We are looking for a source of addtional income (rather than simply disallowance of deductions) to explain the changes. Disallowance of deductions alone won't yield an increase in gross receipts unless the auditor made a mistake.


All this is just speculation since you haven't provided enough detail from the 4549 to make a good guess.

[rfk]

I did not want to...

list all the circumstances of the report but essentially, the gross income was $26,500. After total expenses, the tentative loss was -$55,114. Quite a swing in the opposite direction to create SE income of $52,734 (due to said adjustments).

At this juncture, I am waiting to talk to my client to see if she can provide any pertinent info regarding her expenses denied. She had provided bank statements of the 12 months in question, but they do not trail the expenses (exactly) taken. So I am taking this step by step to help re-construct the totals she took via given source documents

I understand the concept of ordinary and necessary, business purpose, etc. but I want to know of the nuances of using affidavits if necessary in this instance if she does not have proper documentation. The auditor basically runs her audit by rule, but has given some concessions. We are working on what is left; but she is a tough one. Others in our area find her difficult to work with and evidently she has been reprimanded for some of her actions through letters to her supervisor.

But I just need to make sure that we have proper docs and other supporting info to get through this. Yes, if necessary, we will take this to appeals if the client can pay me for doing so. But I have to have something to bat with.

Regards,

rfk

PS: The auditor only looked at TY 2007 (in audit) and TY 2008, not TY 2006, thank God. She felt that inconsistencies of TY 2007 warranted TY 2008 backup too, but left TY 2006 alone.

[JohnH]

Given the info you presented, unless there is another schedule C which this loss offset against, SE income could only be $26,500 at most ($26,500 of gross receipts with no deductions). Taxable income could increase above $26,500, but not SE income.

We're still missing something here - maybe we aren't using the same definition of "Gross Income". In any case, someone providing personal services showing $26K of gross income and a $55K loss may as well have written "AUDIT ME" in big red letters across the face of their return. They're likely either dishonest or clueless - I'd be questioning each and every item they presented me before submitting it to IRS.

[Zee]

rfk- Who prepared this return?

With the information you provided, the return doesn't pass the "smell" test and those same items should have been questioned by the preparer. But, others are correct, even if all the losses are disallowed the maximum taxable income would be limited to the gross income.

I don't think "affidavits" of the expenses will be accepted, my guess is the auditor is going to require hard documentation of each and every significant expense given the description of this return.

[rfk]

Zee from rfk

The return was self prepared through Turbo Tax. I do not think she had minimal understanding of what was going on with her tax preparation capabilities. In my research, through PPC materials, it is shown that affidavits can be used for certain instances. So I am potentially looking at this avenue. I just have to have a strong case if doable.

rfk

[Jiggers]

Self-prepared Returns

Wish the IRS would assess a very heavy penalty for many errors on self-prepared returns so that the taxpayer would consider a tax preparer next year!

[BOB W]

It sounds like the auditor reviewed her bank statements and picked up on deposits that exceeded her reported income.

Yes, this return did say "Audit Me" and probably should have been. May I suggest that your client get a diary and recreate here income and expenses. Although at this late date it will probably be useless.

Written and/or verbal testimony can be used but only when credibility can be established. Right now your client has none.

The lack of effort on your client's side leaves her out in the cold. She may have paid every penny she claimed on her tax return but leaves any help in the air. If she was my client I would try to establish a reasonable compromise with the auditor once you establish that she must of had some reasonable expenses in order to generate her income.

[Zee]

The return was self prepared through Turbo Tax. I do not think she had minimal understanding of what was going on with her tax preparation capabilities. In my research, through PPC materials, it is shown that affidavits can be used for certain instances. So I am potentially looking at this avenue. I just have to have a strong case if doable.

rfk

Yes, it's correct affidavits may be accepted but they'd better be airtight or negotiable. It's hard to offer advice on what might/might not be acceptable without knowing more specifics on each deduction claimed.

[Zee]

It sounds like the auditor reviewed her bank statements and picked up on deposits that exceeded her reported income.

Yes, this return did say "Audit Me" and probably should have been. May I suggest that your client get a diary and recreate here income and expenses. Although at this late date it will probably be useless.

Written and/or verbal testimony can be used but only when credibility can be established. Right now your client has none.

The lack of effort on your client's side leaves her out in the cold. She may have paid every penny she claimed on her tax return but leaves any help in the air. If she was my client I would try to establish a reasonable compromise with the auditor once you establish that she must of had some reasonable expenses in order to generate her income.

Good point! If that's the case, you need to review each & every deposit into your client's checking/savings/etc. accounts and be prepared to explain the source.

[DaveO]

You have a real dandy of a case here rfk. My first question is, "How do you feel about your clients credibilty?"

If you think they are honest but inept then work with them to re-create the expense backup. The money to pay expenses came from somewhere! Do a complete bank record analysis. Document every piece of income and expense making sure the personal expenses catagories contain reasonable numbers.

Does your client have a business plan? They should if they are spending that kind of money trying to grow a business. Have you looked at the worksheets in the turbo tax file? Often people will enter the same expense in two or more places just because they don't know how the program works and have no idea what the finished return should look like.

If the records don't backup the return or your client isn't willing to produce them it's time to back away or at least try to limit the damage to the two years at hand and let the auditor issue their report.

Above all don't let a dishonest client damage your credibility with the auditor.

[joanmcq]

cash T.

The auditor requested the bank statements to do a cash T analysis. In an audit situation, ANY (and I mean any and all) deposits must be substantiated. This means business and personal accounts. The auditor does a simple bit of math; how much in deposits, how much in gross income reported from everything; wages, business, etc. any extra deposits that cannot be documented are added to biz income. for example, in an audit I had, the client had a refund from an insurance company. couldn't prove that was what it was, was added to income. Loan from mom....added to income (tried to get copy of check from mom to client, but mom couldn't produce). So yeah, very easy to get more income on an audit.

The $52,734 is not imputed income, it is disallowed expenses. from what you are saying, she reported a loss of $55114 and $52,734 of expenses were disallowed. That would still leave her with a loss of $2,380. Your figures are not adding up. she would have had to originally had $81,614 of expenses to come to a loss of $55,114. And yeah, that return was screaming to be audited. appears to be like a lot of the ones I see.