A 1040 Audit Mess

[Uncle Sam]

I am in the process of preparing data for an upcoming 1040 audit for a do-it-yourselfer..
Self-employed person, single, who also at times by mistake is given a W-2
instead of 1099 - but really should be 1099. But that's not really my problem.

Besides picking up items for Sec 179 depreciation that are undocumented, but
instead has numerous invoices and receipts for supplies that come close to the
amounts shown on 4562, including depreciating a vehicle, and picking (from what I see)
most of the same expenses on BOTH Schedule C and Form 2106 I have a unique
situation I've never come across before.

This involves 2 years' tax returns.
Year 1 had a Schedule C loss. The loss was NOT taken on 1040.
Instead, Yr 2's Schedule C has a Other Expense labeled Section 465(d)
carryover for exactly the same amount as Year 1 loss.
(I know what must have happened - the person must have checked a box
that he was subject to at-risk rules).

My question is - how do you properly describe this to an auditor - to allow whatever Year 1 losses were (legitimately) on the Year 1 return and remove the deduction from Year 2?

There definitely are other items to be disallowed, and it involves state changes as well - but I've never come across a "465(d)" item for a Schedule C self employment activity.

[appelman]

Don't try to defend what is indefensible.

That is probably the first rule. If it were my client, I would start by preparing the returns as they should have been prepared, and then using these as the basis for any discussions or correspondence with the examiner. It sounds as though you and the examiner can agree right off the bat that the taxpayer did not know what (s)he was doing.

[Gary2]

For what it's worth, the At-Risk rules indeed apply to sole proprietorships, but it's rare that a sole proprietor isn't 100% at risk.

But I agree with the previous post. If necessary, ask for a bit more time to prepare the amended returns correctly. If they understand that you didn't prepare the original, they're usually flexible, since it's easier and faster for them to work with correctly prepared returns. You may even find that once the returns are done correctly, they're less interested in seeing receipts.

The W-2 vs 1099 issue does sound like a problem for you, or at a minimum, extra work. There are some industries in which it's common for people to work as either employee or independent contractor, and to move between the two from job to job. So one possibility is that the W-2s and 1099s are both correct, and you'll have to work on splitting the deductions between Sch. A and Sch. C, and possibly losing some because they don't meet the "required by employer" test.

Worse would be if you actually have to defend either the employee or independent contractor designation.

[Nashville]

Possible Way Out

Rolling forward an "at risk" loss (for which this is likely NOT at risk) may produce lesser tax if rolling from a bad year to a good year. If this is the situation, taking the loss in the appropriate year would be an easy sell to the auditor, although probably not popular with your customer.

I would be far more concerned about recharacterization from a self-employed status to employee status. At one time IRS was wholesale converting 100% of all such 1099s into W-2s, and were getting beat up in the courts. They reacted to this by announcing they were not going to allow the courts to set precedent and continued their recharacterizations. I think the congressional hearings finally put a stop to this, but they are still aggressive. In this situation, they are going to claim the existence of W-2s amongst the 1099s is prima facie evidence of an employee.

[Gary2]

In this situation, they are going to claim the existence of W-2s amongst the 1099s is prima facie evidence of an employee.

Possibly, but we have way too little information to even conclude that the IRS would do this, let alone win.

Here's an easy example: Consider real estate professionals, who often work as independent contractors on commission. However, I know at least one mostly online service that divides the workload differently, and I think puts people on salary. Perhaps a better example would be technical consulting, where someone could be a bona fide independent contractor but wouldn't turn down a temporary gig on a W-2. Or a writer who negotiated a day job (on W-2) that allows moonlighting as an independent contractor.

Your concern is absolutely valid, but let's not jump to conclusions before all the facts are in.

[Kram BergGold]

Not at Risk Rather...

Here is my guess. The Taxpayer used Turbo Tax and checked the box indicating he did not materially participate. This would create the loss carryforward.

[Uncle Sam]

Kram - exactly right. A Turbo-Tax user. That's what he did.

[veritas]

He should have

checked the Tim Geitner box.