Determining whether you have a business or hobby can be confusing, and it is not always clear cut. It has also been the basis of many audits that sometimes result in business expenses being disallowed, which can often cause a high tax increase. This was the case for one taxpayer who had a Schedule C (self-employment) business activity. For several years, he repeated the pattern of showing substantial losses as a result of low income combined with high travel, home office, and other expenses.
Fortunately for this taxpayer, his IRS Audit for 2007 and 2008 landed on the desk of tenacious Sergio R., an audit rep quite knowledgeable about business expense requirements. After reviewing the nine factors used by the IRS and Tax Courts to make Business versus Hobby determinations, Sergio was convinced that this was an activity conducted with the intent to make a profit. Documents were provided to the IRS substantiating the business expenses, along with logs to establish the business connection.
It wasn’t that easy, however, as the IRS was not ready to budge from its position. The IRS examiner responded by requesting all of the taxpayers’ personal and business bank statements from December 2006 through January of 2009.
On subsequent examination reports in reply to our submissions, the IRS disallowed most of the business expenses, and the examiner’s bank analysis revealed unidentified deposits in the amount of $148,125 for tax year 2007 and $13,000 for tax year 2008. Sergio convinced the IRS to focus on the 2007 audit and leave the 2008 unidentified deposits alone, at least temporarily. In July of 2011 he settled the 2008 examination with a total amount due of $607. However, the 2007 tax year report was still showing a total amount due of $48,225, mostly from the unidentified deposits that were included as taxable income.
During continued correspondence with the IRS, Sergio worked with and coached our member on what documents to retrieve and how to organize them. The need of the hour was to prove the legitimacy of the business expenses and that the unidentified deposits were from nontaxable sources. The most challenging part was to demonstrate to the IRS that the taxpayers, in a period of two months, had made several indirect cash transfers between accounts by withdrawing cash from one bank for about $25,000 and depositing the money to another bank.
This was a daunting task, as the IRS was not easily swayed and it took a very long time to bring the case to completion. During the course of the audit the file was transferred to four different IRS examiners, and Sergio, as the POA (Power of Attorney), and our member received eleven IRS notices, most of them examination reports along with Information Document Requests and the Notice of Deficiency.
Though initially unswerving, the IRS eventually reconsidered its position. This was partially due to Sergio’s persistence and his educating the member on how to organize and provide adequate substantiation. Finally, after eighteen months, eleven IRS letters and notices, five submissions to the IRS Audit Unit, several phone conferences and interviews with the four different IRS examiners, Sergio reduced the 2007 tax deficiency from $48,224.74 to $920 without needing to take the case to Appeals. Needless to say, the taxpayer was very grateful!
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