Racing As A Trade Or Business

 I am reading a case that made me grimace. The following is a total NO-NO if you are unfortunate enough to be selected for audit:

As part of the audit RA Chavez issued information document requests to petitioners requesting their accounting records for 2013, but petitioners did not respond. RA Chavez completed his audit without receiving any additional information from petitioners …”

The abbreviation “RA” means revenue agent; those are the IRS folks who do the examinations.

This is not going to turn out well.

… respondent issued … revenue agent reports (RARs) to petitioners with proposed adjustments to tax and accuracy-related penalties. Petitioners did not respond to the … RARs.

Chances are very good that I would have resigned from this representation or refused to accept the client in the first place.

We have, for example, a client who has not filed returns for years. There are mitigating reasons, but not that many or reasons that persuasive for the number of years. My partner brought them in; I looked at their stuff and gave them a list and timetable of what we needed. I reached out to the IRS, explained that they had just hired tax representation and requested time.

I am not going to say that the IRS is always hospitable, but in general they tend to be reasonable if someone is truly trying to get back into the system (except during COVID; the COVID procedural issues have been extensive, unrelenting and extremely frustrating. The IRS really should have stopped issuing notices like government stim checks until it could at least open its mail on a timely basis).

What did my partner’s client do?

They gave us nothing. Two weeks became two months. Two months became three. I received exculpatory e-mails that read like a Grateful Dead tour.

My - and our - credibility with the IRS took a hit.

If they were my client, I would have dismissed them. They are not, however, so I did the next emphatic thing I could do: I will not work with them. We have a younger tax pro here at Galactic Command, and he will take this matter over. He has a nice background in preparation, and I would like to expose him to the representation side of practice. He is somewhat interested (at least, not uninterested), and if he remains in a CPA firm as a career it will be a nice addition to his skill set.

Back to our case.

There is a lot going on, but I want to focus on one issue.

Two families own a construction S corporation (Phoenix). The IRS disallowed $121,903 in 2013 related to car racing activities. More specifically, the racing was by a son of the owners, and his car of choice was a 1968 Camaro.

He started racing it in 2014.

One has to be very careful here. One is taking an activity with a high level of personal interest and gratification and jamming it into a profitable company. It would take minimal tax chops to argue that the racing activity is a hobby or is otherwise personal. The purported advertising cannot be “merely a thin cloak for the pursuit of a hobby.”   

The company fired back with three arguments:

(1)  The racing expenses were ordinary and necessary advertising expenses.

(2)  Phoenix purchased the car as an investment.

(3)  Racing was a separate trade or business from Phoenix and was engaged in for profit.

I do not know if these arguments existed when the return was prepared or dredged-up after the fact, but still … kudos.

Except …

The racing was not conducted under the Phoenix name. There was no company logo on the car, with the possible exception of something minimal on the rear window. There were no photographs or videos of the car on the company’s advertising.

One more thing.

Phoenix did not even separate the car racing expenses as Advertising on its tax return. Instead, it just buried them with “Construction Costs.”

Folks, the IRS does NOT like it when one appears to be hiding something iffy in a big, enveloping category of other expenses. It is, in fact, an indicium of fraud.

The first argument whiffed.

One BTW does not race a car that is held for investment. One stores a car that is held for investment, perhaps taking it to an occasional show.

The second argument collapsed.

That leaves a lot of pressure on the third argument: that the car was its own separate trade or business.

You know what the car did not do in 2013 (the year of examination)? It did not race, that is what it did not do. If one were to argue that the car was a separate trade or business, then one would have to concede that the activity started the following year – 2014 – and not in 2013. All those expenses are what the tax Code calls “startup expenses,” and – with a minimal exception - they have to be amortized over 15 years.

Let me check: yep, this is a pro se case, meaning that the taxpayers represented themselves.

We have said it before: hire a pro, spend a few dollars. You do not know what you do not know.

What would I have advised?

They should have posted photos and videos of that car everywhere they advertised, and I would have recommended adding new advertising venues. I am thinking a video diary: the purchase of the car, its modification, interviews with principal parties, technical issues encountered and resolved, anticipated future race sites and dates.

And yes, I would have put the company name on the car.

Our case this time is Berry v Commissioner, T.C. Memo 2021-42.

A CPA Goes Into Personal Audit

Folks, if you wind up before the Tax Court, please do not say the following:

… petitioner testified that allocating some of the expenses between his personal and business use required more time than he was willing to spend on the activity.”

Our protagonist this time is Ivan Levine, a retired CPA who was trying to get a financial service as well as a marketing business going. He worked from home. He used personal credit cards and bank accounts, as well as a family cellular plan. He also drove two vehicles – a Porsche 911 and a Chevrolet Suburban – for both personal and business reasons. All pretty standard stuff.

The IRS came down like a sack of bricks on his 2011 return. They challenged the following:

(1) Advertising

(2) Vehicle expenses

(3) Depreciation, including the vehicles

(4) Insurance (other than health)

(5) Professional fees

(6) Office expenses

(7) Supplies

(8) Utilities

(9) Cell phone

(10)       Office-in-home

Whoa! It seems to me that some of these expenses are straight-forward – advertising, for example. You show a check, hopefully an invoice and you are done. Same for professional fees, office expenses and supplies. How hard can it be?

It turns out that he was deducting the same expense in two categories. He was also confusing tax years – currently deducting payments made in the preceding year.

The office-in-home brings some strict requirements. One of them is that an office-in-home deduction cannot cause or increase an operating loss. If that happens, the offending deductions carryover to the subsequent year. It happens a lot.

It happened to Mr. Irvine. He had a carryover from 2010 to 2011, the year under audit. The IRS requested a copy of Form 8829 (that is, the office-in-home form) from 2010. They also requested documentation for the 2010 expenses.

COMMENT: Why would the IRS request a copy of a form? They have your complete tax return already, right? This occurs because the IRS machinery is awkward and cumbersome and it is easier for the revenue agent to get a copy from you.

Mr. Irvine refused to do either. The decision does not state why, but I suspect he thought the carryover was safe, as the IRS was auditing 2011 and not 2010. That is not so. Since the carryover is “live” in 2011, the IRS can lookback to the year the carryover was created. Dig in your heels and the IRS will disallow the carryover altogether.

The vehicles introduce a different tax technicality. There are certain expenses that Congress felt were too easily subject to abuse. For those, Congress required a certain level of documentation before allowing any deduction. Meals and entertainment are one of those, as are vehicle expenses.

Trust me on this, go into audit without backup for vehicle expenses and the IRS will just goose-egg you. You do not need to keep a meticulous log, but you need something. I have gotten the IRS to allow vehicle expenses when the taxpayer drives a repeating route; all we had to do was document one route. I have gotten the IRS to accept reconstructions from Outlook or Google calendar. The calendar itself is “contemporaneous,” a requirement for this type of deduction.

BTW the tricky thing about using Outlook this way is remembering to back-up Outlook at year-end. I am just saying.

You know Mr. Irvine did not do any of this.

Why?

Because it would have required “… more time than he was willing to spend on the activity.”

This from a CPA?

Being a CPA does not mean that one practices tax, or practices it extensively. I work tax exclusively, but down the hall is a CPA who has careered in auditing. He can exclaim about myriad issues surrounding financial statements, but do not ask him to do a tax return. There are also nouveau practice niches, such as forensic accountants or valuation specialists. One is still within the CPA tent, but likely far away from its tax corner.

Although a CPA, Mr. Irvine could have used a good tax practitioner. 

When Is A Car Not A Car?

I had a conversation today with someone who wanted to understand the “tax side” of a series of transactions. More specifically, transactions that – to a non-tax person – would appear to have no tax side at all.

It made me think of a tax case I read while grabbing a quick dinner one night during busy season.

          COMMENT: Glamorous life, eh?

Think of your car. In the eyes of the IRS, is it one asset or is it a collection of interdependent systems that – together – form a car but which can be separately depreciated, abandoned, sold or whatnot?

This is easy: it is one asset. You start depreciation on the whole thing and you eventually sell or abandon the whole thing. You are not picking and choosing manifolds from rotors.

Except if ….

It is a race car.

There is a racing team. After each race the team strips down the car, perhaps to the nuts and bolts. They decide as they go though:

(1) Damaged parts

(2) Obsolete parts

a.    There is enough technological change in racing that a part can become obsolete almost overnight.

(3) Stress and wear parts

a.    These are not damaged or obsolete, but the team knows they have very limited life left because of the high stress and wear of racing.

                                                             i.     Some parts can be reused in a race.

                                                           ii.     Some parts cannot be raced again, but would be fine for a show car or pit car.

The team had a question for the IRS: can they deduct some of this stuff when they disassemble the car after every race?

To a tax nerd, the question is whether there has been a “disposition.” That is the trigger that allows one to remove an asset from a depreciation schedule and claim a gain or loss on the tax return – hopefully a loss.

But what does “disposition” mean to a race car?

Turns out that disassembling it after every race is the disposition. The IRS took pains to point out that the same car is never raced twice. Dale Earnhardt Jr races number 88, but you never see the same number 88 twice.

          COMMENT: There is a Zen quality to this.

That makes it easy: if you get rid of a part, you can write-off its remaining cost.

But what if you keep the part?

To phrase it another way: what if you had a disposition but did not, you know, dispose of the part?

Now you have an accounting twist. You value the part at its invoice cost (which is normal) and then adjust down for the amount of useful life already expired. Let’s say you have a $7,500 part, and the team experts say that it has 40% useful life remaining. Well, that part stays on your books at $3,000 ($7,500 times 40%). The other $4,500 gets written-off as a loss.

Heck, you can deduct a loss even if you keep the part!

Rinse and repeat for however many parts make up a race car.

COMMENT: I feel sorry for the person who has to bookkeep for all this.

I wonder if racing aficionados would recognize which racing team the IRS addressed in PLR 201710006.

A PLR is a private letter ruling, meaning that someone presents a situation to the IRS and requests the government position on tax consequences. This is generally done in advance to obtain some certainty to a transaction, especially if there is a lot of money involved.

And PLRs are published. For many years the IRS did not publish them, but there was a famous lawsuit requiring the IRS to do so. There was an issue, however, as the IRS is not allowed to release confidential information. The answer was heavy redaction of any confidential information while drafting the PLR.

Such as the name of the racing team.

IRS Small Business Audit Areas

The IRS has announced selected business areas it is prioritizing for audit this upcoming fiscal year. The IRS is increasingly focused on small business underreporting, which it considers responsible for the majority of a $450 billion tax gap. Here are the areas:

1.      Fringe benefits, especially use of company cars

The IRS is finding that employers are not correctly reporting employees’ personal use of company vehicles on Forms W-2.

2.      Higher income taxpayers

The IRS will focus on self-employed taxpayers with gross receipts (that is, before expenses) of more than $1 million.

3.      Form 1099-K matching

Forms 1099-K report payments from credit cards and payment clearinghouses (such as PayPal). The IRS granted a reprieve for 2012, but it announced that it will start Form 1099-K matching in 2013.

4.      The small business employee health insurance tax credit

The IRS wants to make sure that small business employers and tax exempts are complying with credit eligibility requirements.

5.      International transactions

The IRS has announced its third voluntary foreign bank account initiative and intends to look for offshore transactions.

6.      Partnership returns reporting losses  

This is a new area of emphasis. Expect the IRS to look into partnerships reporting large losses.

7.      S corporations reporting losses and reasonable officer compensation

The IRS will be looking at S corporations claiming losses, looking for losses taken in excess of shareholder basis.

The IRS is also interested in profitable S corporations reporting little or no salary to officers.

8.      Proper worker classification

The IRS is interested in employer treatment of worker versus independent contractor status. The IRS thinks there is significant noncompliance in this area.

Another Warning on Deducting Auto Expenses

There is a very recent case concerning tax deductions for business use of a vehicle that I am considering as mandatory reading for many of our clients.

The pattern is repetitive. Either the business provides the car or the employee uses his/her car for business and is not reimbursed. Tax time we ask the following questions: what is your mileage? What do you have as documentation to support that mileage? We review the danger associated with this tax deduction (the IRS will disallow it if you cannot back it up), to which it seems most of the clients roll their eyes and go “yea, yea.”

Well, Jessica Solomon just got schooled. It’s a shame, too, as it sounds like Jessica was trying to do the right thing, but she just didn’t know what that meant. Let’s look at Jessica Solomon v Commissioner.

Jessica Solomon moved from Illinois to Missouri in 2006. First, let me say that I went to the University of Missouri, so I approve of her move. Second, she started work as a commission-only salesperson for seven months – June through December. She was peddling office supplies. Every day she started the morning at the company office in St Louis, and at the end of the day she finished with an evening meeting there. She only made $3,307 in commissions. Considering that she was reimbursed for NOTHING, it sounds to me like this was a waste of her time.

She kept a log in her car. At the start of the day she wrote down her mileage, and at the end she noted her mileage. Unfortunately, there was no other information, such as the towns, prospects or customers she was visiting. It was bare-boned, but it was something.

At the end of the year she went to H&R Block. They deducted her business expenses, including 18,741 business miles.

In January, 2009 the IRS issued a statutory notice disallowing all her mileage and employee expenses for 2006. Jessica, bless her heart, went to Tax Court representing herself (this is called “pro se”). It did not go well for Jessica.

Unfortunately, the court was right. Let’ go through this…

* It is an axiom in tax practice that deductions are a matter of legislative grace. This is fancy way of saying that there is no deduction just because you really, really want there to be one.
* If a taxpayer presents credible evidence on a factual issue concerning tax liability, Code Section 7491(a) shifts the burden of proof to the IRS.
* If Section 7491(a) kicks in, the IRS (or Court) may even estimate the amount of expenses, if the supporting documentation is poor or even nonexistent.
* There are some expenses where the burden of proof does not shift under Section 7491(a).
* A car is one of those expenses. Car expenses are addressed under Section 274(n).
* Section 274(n) says that no deductions are allowed with respect to listed property (think a car) unless very specific documentation requirements are met:

** The amount
** The time and place
** The business purpose
** The taxpayer’s relationship with the persons involved

The Court looked at her log. The court had several problems;

(1) The log noted only the beginning and ending mileage for each day

(2) The log included a 27 mile commute

(3) The log may have included personal trips

So far, I could have worked with this. I would ask Jessica for a Day Runner or some other record of who she visited, where and etc. In fact, had she submitted contact reports to the company, I would ask the company to provide copies for her tax audit. I need corroborating evidence. The evidence does not have to be on the same sheet of paper. In truth, it need not even had been created at the time, although that would of course carry more weight.

Unfortunately Jessica could not do this. Here is the Court:

Petitioner did not present any evidence at trial, such as appointment books, calendars, or maps of her sales territories, to corroborate the bare information contained in the mileage log…”

But the court KNEW that she had to use her car – right? Surely the Court would spot her something.

Although we do not doubt that petitioner used her Chevrolet Cavalier for business between June and December, 2006, we have no choice but to deny in full petitioner’s deduction for mileage expenses. For reasons discussed …, petitioner’s mileage log does not satisfy the adequate records requirement of Section 274(d).”

No mileage deduction for Jessica.

As I said, perhaps this case should be mandatory reading for many of our clients.