When A Tax Audit Is Not An Audit

 

I am cleaning-up files here at Galactic Command. I saw an e-mail from earlier this year chastising someone for running business deposits through a personal account.

I remember.

He wanted to know why his extension payment came in higher than expected.

Umm, dude, you ran umpteen thousands of dollars through your personal account. I am a CPA, not a psychic.

Let’s spend some time in this yard.

If you are self-employed – think gig worker – and are audited, the IRS is almost certain to ask for copies of your bank accounts. Not just the business account(s), mind you, but all your accounts, business and personal.

I have standard advice for gig workers: open a separate business account. Make all business deposits to that account. Pay all business expenses from that account. When you need personal money, draw the needed amount from the business account and deposit to your personal account.

This gives the accountant a starting point: all deposits are income until shown otherwise. Expenses are trickier because of depreciation, mileage, and other factors.

Is it necessary?

No, but it is best practice.

I stopped counting how many audits I have represented over the years. I may not win the examiner’s trust with my record-keeping, but I assure you that I will win their distrust without it.

Does the examiner want to pry money from you? You bet. Examiners do not like to return to their managers with a no-change.

Will the examiner back-off if all the “i’s” are dotted? That varies per person, of course, but the odds are with you.

And sometimes unexpected things happen.

Let’s look at the Showalter case.

Richard Showalter (RS) owned a single-member LLC. The LLC in turn had one bank account with Wells Fargo.

This should be easy, I am thinking.

RS did not file a tax return for 2013.

Yep, horror stories often start with that line.

The IRS prepared a substitute for return (SFR) for 2013.

COMMENT: The IRS prepares the SFR with information available to it. It will add the 1099s for your interest and dividends, the sales price for any securities trades, any 1099s for your gig, and so forth. It considers the sum to be taxable income.

         Where is the issue?

Here’s one: the IRS does not spot you any cost for securities you sold. Your stock may have gone through the roof, but the odds that it has no cost is astronomical.

Here is another. You have a gig. You have gig expenses. Guess what the IRS does not include in its SFR? Yep, you get no gig expenses.

You may be thinking this has to be the worst tax return ever. It is leaving out obvious numbers.

Except that the IRS is not trying to prepare your tax return. It is trying to get your attention. The IRS throws an inflated number out there and hopes that you have enough savvy to finally file a tax return.

So, RS caught an SFR. The IRS sent him a 90-day notice (also known as a statutory notice of deficiency or SNOD), which is the procedure by which the IRS can move your file to Collections. You already know the tender mercies of IRS Collections.

RS responded to the SNOD by filing with the Tax Court. He wanted his business expenses.

Well, yeah.

RS provided bank statements. The IRS went through and – sure enough – found about $250 grand of deductions, either business or itemized.

That turned out rather well for RS. He should have done this up-front and spared himself the headache.

Then the IRS looked at his deposits. Lo and behold, they found another hundred grand or so that RS did not report as income.

It is not taxable, said RS.

Prove it, said the IRS.

RS did not.

COMMENT: It is unclear to me whether this disputed deposit was fully or partially taxable or wholly nontaxable. The deposit came from a closing statement. Maybe I am being pedantic, but I expect a cost for every sale. The closing statement for the sale is not going to show cost. Still, RS did not argue the point, so ….  

Now think about what RS did by getting into IRS dispute.

RS filed with the Tax Court because he wanted his deductions. Mind you, he could have gotten them by filing a return when required. But no, he did this the hard way.

He now submitted invoices and bank statements to support his deductions.

However, using bank statements is an audit procedure. Why is the IRS using an audit procedure?

Well, he is in Tax Court and all. He picked the battleground.

Had RS filed a return, the IRS might have processed the return without examination or further hassle. Since bank statements are an examination step, the IRS would never have seen them.

Just saying.

Was this this fair play by the IRS?

The Court thought so. The IRS cannot run wild. There must be a “minimal evidentiary showing” tying the taxpayer to potential income. The IRS added up his deposits; that exceeded what he reported as income. Seems to me the IRS cleared the required “minimal” hurdle.

By my reckoning, RS should still come out ahead. The IRS bumped his income by a smidgeon less than a hundred grand, but they also spotted him around a quarter million in business and itemized deductions. Unless there is crazy in that return, this should have improved his tax compared to the SFR.

Our case this time was Richard Showalter v Commissioner, T.C. Memo 2022-114.