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.
Not a bit.
