How To Hack Off An IRS Auditor

Let’s discuss an excellent way to anger a revenue agent auditing your tax return.

Eric and Mary Kahmann have owned a jewelry business for 45 years. They report the business on their personal return as a proprietorship (that is, a Schedule C). they primarily sell at shows throughout the United States, although they also sell through Amazon and PayPal.

PayPal introduces a tax variable: Form 1099-K.

Yep, another blasted 1099. This time Congress was concerned that people were selling stuff (through Amazon, for example) and not correctly reporting their income. Amazon will sell your stuff, but the cash is likely going through Pay Pal or its equivalent. Do enough business and PayPal will send you a 1099-K at the end of the year.

Issue number one.

In addition, Mr. Kahmann’s two brothers were also in the jewelry business. Whereas they did not work with or for him, they would use his two merchant accounts to process payments.

Issue number two.

The IRS audited the Kahmann’s 2011 year.

Why? Who knows. What did not help were the following numbers:

Gross sales reported by the Kahmanns     $128,070

Gross sales reported on the 1099-Ks         $151,834

Guess what? This happens quite a bit, and it does not necessarily mean shenanigans. I will give you one example:

Customer refunds

If one accounts for customer refunds by subtracting them from sales, one can have the above discrepancy. The 1099-K does not – of course – know about any refunds.

The revenue agent asked for bank statements.

COMMENT: This has become standard IRS procedure for a Schedule C audit. It means nothing. You can however flame it into roaring meaningfulness by …

The Kahmanns refused to provide the bank statements.

Brilliant!  

I would seriously consider firing a client who did that to me. Is it a pain? Yes. Will the bank charge you for the copies? Yep. Is it fair? Fair is beside the point. It is what it is.

The revenue agent issued a summons to the bank for the three accounts she knew about. 

COMMENT: Yes, the IRS can get to those accounts. In addition, now the agent has to question whether she knows about all your accounts. Your chances of getting her to believe anything you say are falling fast.

Let’s grade the Kahmanns’ conduct during this audit so far:

                  F

The agent got the bank statements and added up all the deposits. The total was $169,603.

Wait, it gets better.

She could not trace one of the 1099-Ks into the bank statements, so she added that number ($15,745) to the $169,603. She now calculated gross receipts as $188,073.

The Kahmanns have a problem.

They have to show that some of those deposits were not income. Could be. Perhaps they borrowed money. Perhaps they transferred monies between accounts. Perhaps they received family gifts.

Perhaps Mr. Kahmann deposited his brothers’ PayPal transactions, given that they were using his merchant accounts.

There are two technical issues here that a tax nerd would recognize:

(1) There is recourse to having the IRS add-in $15,745 from a 1099-K just because the agent could not figure-out how it was deposited. A taxpayer can shift the burden of proof back to the IRS, meaning that the IRS is going to need something more than a piece of paper with “1099-K” printed somewhere on it.

There is a catch: you must cooperate with the IRS during the exam. Guess who did not cooperate by refusing to provide bank statements?

Bingo!

(2) Alternatively, a taxpayer can show that the deposits are not income.

Say that a deposit belonged to Kahmann’s brother. You can have the brother (or his accountant, more likely) show that the deposit was included in gross sales reported on the brother’s tax return.

It’s a pain, but it is not brain surgery.

The Kahmanns provided letters from the brothers.

The IRS wanted to meet with the brothers.

The brothers did not want to meet with the IRS.

The Kahmanns submitted books and records to support their tax return. The handwriting appeared to have been written all at once rather than over the year. The ink was also the same throughout.

Unlikely. Suspicious. Dumb.

You can guess how this wound up.

The Court agreed with the IRS recalculation of income. The Kahmanns owed big bucks. There were penalties too. 

Normally I am quite pro-taxpayer.  Am I sympathetic this time?

Not a bit.