NAICS code

[JoshinNC]

Client for whom I am doing state tax audit has asked me a question that I initially answered with a flat no, but want to check everyone else's opinion. Client is employed as a computer software consultant, via W-2. He also started LLC doing concrete resurfacing work in 2004. He reported expenses of $62,000 and $73,000 in '04 and '05, with no income either year. I flat told him I wouldn't even prepare a Sch. C for the LLC for 2006 (my first year as his accountant, the other years are TurboTax returns) without income reported. He says, "I can have my employer switch me to an IC, get a 1099 and report that on my C." I said no because concrete resurfacing and software consulting are so divergent in nature it wouldn't fly. He said he did research and that the NAICS code doesn't matter and he can report it that way. I cam ewithin inches of telling him to get off my phone and never call me again, but I wanted to make sure I wasn't out in left field. Any ideas?

[dsi]

I wouldn't touch this. I don't have a cite, just a gut feeling that it isn't right. However, I'm in a position to turn away business, so it's much easier for me to send them elsewhere.

[JoshinNC]

I'm going on gut too,

but I'm thinking there must be something somewhere that states this. I looked briefly, but didn't want to spend alot of time on a deadbeat client. He pays well, but I don't have time to research facts everytime a client questions my abilities.

[jainen]

costs of running a business

>>the NAICS code doesn't matter<<

It's usually a bad sign when clients start hitting you with jargon. At least he is right about this -- it doesn't matter. Those are private industry codes which may be useful at times but don't by themselves determine tax treatment.

Still, you can say that a sole proprietor is the same entity as the individual, and therefore all Schedule C's could be combined. Of course, that is not his current situation anyway, which is all you can work with. He has a W-2 for last year. If that were revoked it might be another matter, but that hasn't happened (and it seems an unlikely thing).

Lack of income does not necessarily preclude Schedule C deductions, but after two or three years it does raise the question of whether he is acting in a business-like manner with a profit motive. I would ask him to clarify that issue by explaining the business purpose, especially for travel and entertainment expenses, office in home, and other things that might more appropriately be considered personal costs. I would also consider whether he has been dealing with start-up expenses rather than costs of running a business.

[Uncle Sam]

NAICS code

I've always believed that these codes had some meaning to IRS (and States for that matter) in determining industry standards for compliance reporting. That would have, or should have, some bearing on audit potential.
I remember in mid 1990s when MSSP Guides first came out, they all were based on a pilot test program somewhere in the country basing their audit programs on specific industry standards for accepting/rejecting audit results.

[JoshinNC]

As a matter of fact certain businesses

I've always believed that these codes had some meaning to IRS (and States for that matter) in determining industry standards for compliance reporting. That would have, or should have, some bearing on audit potential.
I remember in mid 1990s when MSSP Guides first came out, they all were based on a pilot test program somewhere in the country basing their audit programs on specific industry standards for accepting/rejecting audit results.

identified under certain NAICS codes are ineligible for certain types of tax treatment, including cash vs. accrual accounting. I have a hard time believing a taxpayer, especially one already under review by a state tax authority, would be able to combine income from very divergent income sources for reporting without some type of disclaimer or identification.

[Bees Knees]

TTB, page 5-7, "If a taxpayer owns and operates more than one sole proprietorship, do not combine the activities. Rather, file a separate Schedule C for each business activity. Combining separate activities on one Schedule C could result in negligence penalties."

Then it cites Rev. Rul. 81-90 which is the case of a taxpayer who was a self-employed professional, and also owned a tax shelter where he did not participate materially. He reported both activities, plus his wife's self-employment income, all on one Schedule C. The ruling said:

"Each of the three activities, for income tax reporting purposes, requires the filing of a separate Schedule C. The failure to file three separate Schedule C's is evidence to be weighed in determining whether A and B believed they had sufficient basis for their position, and, therefore, under such circumstances, whether the understatement could be due to negligence or intentional disregard of rules and regulations as to the items giving rise to the deficiency."

[JoshinNC]

Well

I think I have my answer. Thanks Bees!

[George Boutwell]

Then it cites Rev. Rul. 81-90 which is the case of a taxpayer who was a self-employed professional, and also owned a tax shelter where he did not participate materially. He reported both activities, plus his wife's self-employment income, all on one Schedule C.

The other side of the coin is that if the tax-shelter deductions had not been disallowed, the negligence penalties would not have been an issue. IRS did not try to assert failure-to-file penalty, so apparently they considered the return they received as valid.

However, the message from the revenue ruling that might be most appropriate to review here is:

For examples of penalties which may apply to a preparer of the return, see sections 6694(a) and (b) of the Code. See also the penalty provided in section 6653(b) for application in appropriate cases where there is evidence that the failure to report properly A's and B's income and deductions was due to fraud.

[Bees Knees]

The other side of the coin is that if the tax-shelter deductions had not been disallowed, the negligence penalties would not have been an issue. IRS did not try to assert failure-to-file penalty, so apparently they considered the return they received as valid.

I agree that if the only problem was combining a bunch of Schedule Cs into one, then there would be no issue here.

However, the original post had a situation where someone was trying to deduct expenses without any corresponding income. After 2 years of this, the preparer says enough already. So the guy wants to combine it with another business to “hide” the deductions. Why? Why the losses with no income? What is the taxpayer trying to pull?

In the Revenue Ruling cited, essentially the same thing happened. The taxpayer tried to “hide” tax shelter losses inside the same Schedule C as a profitable profession. After deciding that not all deductions were allowed at audit, the IRS used that disregard of the rules as further evidence that the taxpayer was subject to a negligence penalty. The taxpayer wasn’t necessarily being penalized for combining income on a Schedule C. The taxpayer was being penalized for underreporting income. However, underreporting in itself is not necessarily negligence. The fact that the taxpayer was negligent in preparing a correct tax return with multiple Schedule Cs was used against him as further proof that he was negligent in underreporting his income.

Its like getting caught speeding. If speeding is all you are doing, the cop might let you off with a warning. But if you also have an open bottle in your car, the speeding ticket is going to be the least of your worries.

[dsi]

This client sounds way to sloppy for me. I would insist he keep his businesses separate, with excellent bookkeeping records. Good luck Josh.

[geekgirldany]

NAICS code does matter in the long run. I have a customer that was audited. The IRS determined during a audit that the wrong NAICS code was being used and switched him to another one. Which was actually correct. What happened that this threw the corporation as having to be reported as accural instead of cash. If it wasn't for the small business inventory rule (under 1 million) there would have been a problem.

If he was incorporated reporting as a C or S Corp it might be different... might. I have a customer running two businesses under the same corporation. But books are kept separate for both businesses. I thought this would be very helpful if ever audited.

I think you have already had your question answered but just thought I would add to it.