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.

Why Does The IRS Want To Tax Donations Raised For A Cancer Patient?

Have you heard of a website called GoFundMe?

We are talking crowdfunding, and the technology is a dozen or so years old. It is made possible by the internet. Think of a cause, a website and a means to process payments from interested parties. The cause can vary. It might be a business startup, unexpected medical expenses, a legal defense or even a wedding fund.

There are number of crowdfunding websites, bit today our story involves GoFundMe.

I am reading the story of Casey Charf, a young Omaha woman who in 2013 was involved in a bad car crash. She had broken her neck and back. While in the hospital the doctors discovered that she had cancer.

She was interviewed by local television and her story went viral. There were fundraisers for her medical expenses, and toward that end her sister set up a GoFundMe account.

More than a thousand people donated online, raising over $50,000.

Casey has spent the last two years on medical travel and receiving treatment. The cancer unfortunately is still there, but at least it does not appear to be spreading.

In March of this year the IRS dropped in. They sent a notice that the monies raised through GoFundMe should have been reported as taxable income, and to please remit over $19 thousand in taxes, penalties and interest.

Needless to say Casey Charf is contesting the matter.

And I think she will win.

I speculate, but I think I know what triggered the IRS notice. I suspect Casey received a Form 1099-K notice.

The IRS uses the Forms 1099 series to have a third party report amounts paid you and likely representing income. A bank would send you a Form 1099-INT for interest paid on your savings, for example.

The 1099-K follows in that spirit, but it is sent by payment processors. This immediately tells us that we are dealing with debit or credit cards. Why did this enter the tax Code? Think eBay. People were conducting business activities but not sending the government its due. Congress therefore mandated that the companies that processed the payments issue annual 1099s, and it delegated to the IRS how to handle further details.

The IRS published Form 1099-K and said that the payment processor was required to file the form if (1) gross payments to a person exceeded $20,000 or (2) there were more than 200 transactions with a given person.    

GoFundMe uses WePay as its payment processor. I am willing to bet nickels to dollars that WePay issued a 1099-K to Casey Charf.

And the IRS sent a notice.

Why?

Because the IRS presumes that 1099-Ks are for business activity.

I suspect the IRS was trying to find a “business” number on the tax return that matched or exceeded the 1099-K. Finding none it churned out a notice.

Can the IRS not tell that monies are being raised for a charitable cause?

In short, no, not really.

And there is the unfortunate, inside truth of today’s IRS: every year more and more functions are being automated. The practice started out innocently enough: have third parties send information to the IRS and then have IRS computers match that information to your tax return. 

That worked well enough years ago, when reporting requirements were much lighter. They are becoming – if they haven’t already become – onerous, as the IRS wants to know every creak in the economy so Congress can tax it. Many of these notices are wrong, but they still cause angst and cost taxpayers professional fees. The dirty secret is that the IRS is intentionally shifting the cost of administering tax law to taxpayers with all these notices. They can send out anything and force you to explain how they are wrong. Fail to explain and the IRS can (and likely will) assess you.

Back to our story.

I see no reasonable tax theory under which these payments are income to Casey. There is no business activity, nor is there an employment or contractor relationship providing a backdrop for earnings from personal services. I suppose one could argue that it is akin to a lottery or bag of money found on the street, but that seems a stretch.

There is a donative intent, although as structured the amounts raised do not appear to rise to the level of a tax-deductible donation. There are strict rules with deducting payments made directly to an individual, and for the most part they require the participation of a 501(c)(3).

From a tax perspective these payments most closely resemble a gift. Gifts are not taxable.

Which is why I believe Casey Charf will win on this issue.

More importantly, may Casey have a full and speedy medical recovery.

Has The IRS Noticed You?

My partner asked me today whether I thought we are seeing more tax notices. We are pretty keen on this issue, as tax notices – any tax notice – reflect badly on the quality of our work.  I would begin to question my dentist if I routinely received notices from the Internal Dental Service, the Ohio and Kentucky Departments of Dentistry, the Cincinnati Dentistry Division, …. You get the idea.

Have you heard about the IRS’ recent fishing expedition? It is called “Notification of Possible Income Underreporting.” There’s a name. Why don’t they just bash down your door and arrest you? 

What is causing this is the use of debit and credit cards. The payment settlement entities (think Visa) and third-party payers (think PayPal) are now required to relay financial data to the IRS via Forms 1099-K. The IRS has their nose into how much you are depositing into your business checking account. You can pretty much guess that the IRS is matching A to B and is sending out letters when they do not match.

There are four possible letters the IRS may send, each requiring its own response:

1. Letter 5035 – the softest of the letters. You do not need to respond.
2. Letter 5036 – you want to respond within 30 days as the IRS reserves the right to assess you.
3. Letter 5039 - you now need to complete yet another form – Form 14220 Verification of Reported Income. Lucky you.
4. Letter 5043 – if you believe that the return you filed is accurate, then you must provide the IRS with a written explanation of why you believe that. (Think about that sentence for a minute).  Again, failure to respond may trigger an assessment.

Now, a normal person would anticipate that the IRS would compare what a business reports as gross revenue to the 1099-K.  As long as the first number equals or exceeds the second, all should be OK.

Oh, to be young and naive.

That is NOT what the IRS is doing.

How can the numbers go awry? Well, a couple of very common transactions come immediately to mind: 

• The 1099-K “sales” will include sales taxes. Generally speaking, accountants do not include sales taxes in “sales,” primarily because sales taxes are not sales. A business collects sales taxes as an “agent” and is required to remit them to the state tax department. Does this sound like “sales” to you?
• The 1099-K includes cash draws by the customer. Say you buy something and take an extra $20 in cash. Again, most accountants would not report that transaction as a “sale.” Same reason as (1).

The IRS has created an alternate universe. How? Well, they did a study, apparently super-secret and better concealed than donor lists to Section 501(c)(4) nonprofit applicants or the tax records of the American Issues Project. This study has determined sales levels for different lines of business – dry cleaners, florists and so forth – as well as “average” proportions of debit and credit card sales to total sales. The IRS has one piece of this information – the debit and credit cards – so now it backs into expected sales (based on averages). If you report lower sales than that… BAM!... here’s your letter.

Why does this upset me?

(1)  This exercise is based on averages. The IRS is wasting a taxpayer’s time because somebody-who-knows-somebody-overheard-somebody-talking-about…. You get the idea. It would waste less time and possibly be cheaper for the government to just mug the taxpayer.

(2)  How much of a tax professional’s time – my time –are they wasting? Can I even bill for this nonsense? Last time I checked, the IRS is still not sending me a paycheck. Maybe I should start invoicing them.

(3)    Understand what the IRS is doing here: they are shifting an examination function onto the shoulders of the taxpayer and his/her tax advisor. The IRS can potentially ask for anything: maybe the name of the church you attend. It can then conduct a “study” to determine average donations to that church. Guess what? If you exceed that amount, get ready for a notice. Where does this end? If the IRS wants to examine you, then let them examine you! At least they would have skin in the game, as they would have to pay the examiner’s salary. Perhaps that would cool their heels a bit.  

(4)    The backbone of our tax system has been voluntary compliance. As the nation becomes increasingly bankrupt, the “voluntary” part is becoming laughable. The government – enforcing through the IRS – is forever wringing us for more information: for FBARS, for cost basis on the mutual fund you sold, for the tax ID number of your child’s day care, for foreign bank reporting (FATCA) on your account overseas.

Think about that last one. How would you feel if Japan required all U.S. banks to report to Japan on accounts owned here by Japanese citizens? And – to put the cherry on the sundae – slap a 30% tax on any U.S. bank obstinate enough to not comply with Japan’s decree? I tell you what I would do if I were a bank president: I would not accept accounts from Japanese citizens. Guess what foreign banks are doing to American expats. Congratulations, you are smarter than an average U.S. Representative or Senator.

Going back to my partner’s question: yes, we are seeing more notices these days, because almost every year the IRS finds new ones to send out.

Goodness knows what they will trot out next year.