While your chances of being audited may be relatively low, planning as if you will hear from the IRS could help you survive a challenge. A recent U.S. Tax Court case illustrates why keeping meticulous records and operating in a business-like fashion can mean the difference between claiming tax deductions and having them disallowed.
Facts of the Case
There were many issues involved in the recent case of a married couple and their ventures. Edmond Heinbockel operated a video game and training simulations company, named Visual Purple, LLC (VP). Two of its customers were the FBI and the Department of Homeland Security. Lydia Heinbockel operated a "trunk show" or personal shopping business during the years at issue.
The Tax Court called the couple "possessed by entrepreneurial spirit" since they were also involved in other activities such as plane chartering, grape farming and money lending. The Heinbockels claimed that their income was significantly offset by losses from these three activities during the years in question, while the IRS asserted that the couple was not motivated by profit.
Spotty Records, Informal Procedures
Edmond Heinbockel traveled for VP and because he was a pilot for many years, he decided an airplane would be useful in the business. He felt that with VP as the anchor client, and rent from other users, a plane chartering venture would be profitable.
He bought a four-passenger, single-engine plane and called the entity Collective Flight. Revenue was lower than anticipated because of limited use. When VP did rent the plane, the taxpayer often decided not to bill the company because of its cash flow problems. In addition, the taxpayer was unable to convince others to rent the plane because it was not the type of airplane they wanted to use.
On the loan agreement for the plane, there was space to designate the purpose of the aircraft. In this space was typed "PERSONAL." There were no written contracts between Collective Flight and VP. When VP was billed for use of the aircraft, Collective Flight used a low mileage charge rather than an hourly rate, which was the industry standard.
The Tax Court found the overall arrangement "informal," and the records "spotty." Collective Flight was not conducted in a business-like manner "from day one," the court added. In addition, the taxpayer's time devoted to the business was minimal and he kept no record of his hours.
Factors Considered by the Tax Court
Under the tax code, you can deduct all "ordinary and necessary expenses" paid or incurred in carrying out a trade or business. But before determining whether deductions are allowable, a taxpayer must show that he or she is engaged in the activity with the actual objective of making a profit.
Here are the factors the Tax Court and the IRS considers with the "hobby loss" rules:
The court looked at the factors used to determine whether an activity is for profit (see right-hand box) and determined it was not a trade or business.
The losses were disallowed since all the factors weighed against Heinbockel. The court also denied a loss on the sale of a truck the taxpayers claimed was used exclusively in the plane chartering activity.
Other issues in this case were found in Lydia Heinbockel's personal shopping business. One of the questions the court had to answer was: Who owned it? Despite the business being named "Lydia's World," the husband was listed as the owner. Other than the opportunity to avoid self-employment tax, there didn't seem to be any reason for the husband to be the owner.
By attributing the Lydia's World business to the husband, the couple wouldn't owe any additional FICA taxes on its business income because he already reached the Social Security tax threshold for the years at issue.
Based on the wife's testimony, the court quickly decided the business was hers and the income should be attributed to her.
No Contemporaneous Logs
The IRS and the Tax Court also found poor substantiation for the deductions claimed.
The wife claimed 100% of her luxury autos were used for business, testifying that she marketed herself "24-seven." She said she would go to the gym where she did "30% to 40% to 50%" of her business and then deliver an order to someone she met there. The Court understood the melding of personal and business activities, but the lack of recordkeeping resulted in a loss of any deduction for auto expenses.
The IRS disallowed meals during various business trips with her husband, along with other meal and travel expenses. In addition to the lack of substantiation, the court noted several times that many of the expenses appeared to be personal and not business related. The fact some of them coincided with birthdays and other special occasions created suspicion. The taxpayer's testimony didn't help.
The court stated: "The absence of contemporaneous logs combined with Lydia's often inconsistent testimony, and the numerous occasions where these alleged business trips appeared to be draped with personal pleasure, cause us to find that none of the travel and meals and entertainment expenses met the business purpose requirement" of the tax code.
Finally, Lydia's World claimed some $11,000 in marketing expenses. But these amounts were really gifts (in the form of leftover inventory) to individuals who helped with her shows. Gifts are limited to $25 per recipient per taxable year and the documentation rules are strict.
The court sided with the IRS and allowed just $75 in deductions for gifts to three individuals. (Heinbockel, T.C. Memo. 2013-125)
Lessons to Be Learned
These are only some of the issues that were examined in this case. The overall lesson here is to conduct your business as if you know you are going to be audited (even though, the odds are generally slim). Here are some considerations:
1. Transactions between related parties require more, not less, documentation than those between unrelated parties. Draft a written lease, rental agreement, promissory note, bill of sale, employment contract, etc. Deals should be similar to what two unrelated parties would agree to in "an arms' length transaction". Go through the same formal motions as similar businesses. In this case, for example, the taxpayer rented the plane by the mile instead of by the hour, which went against industry standards.
2. Do you have a board of directors or investors? Get them to approve deals. In this case, the taxpayer admitted that the company's other investors probably didn't know about the arrangement.
3. After you have an agreement with a related business, make sure you stick to it.
4. Meals and travel and entertainment expenses are always a magnet for attention. Therefore, be prepared for a challenge. The court concluded some of the meals and travel expenses for Lydia's World were personal and not deductible even if adequately documented. But the Court disallowed all the expenses.
5. Documentation is critical. Record the date, cost, place of meal or entertainment, type of expenditure, names of persons entertained, business discussed, and business relationship. Keep a contemporaneous log or diary. Don't try and go back and record expenses long after they are incurred.
6. You may be able to use your own statement, written or oral, to support an element, but this should be a fallback position. The credibility is generally less than a contemporaneous written record.
7. If you must testify about what is claimed on your tax return, make sure your testimony is knowledgeable and consistent. Get advice from your attorney before going to court.
8. Be particularly careful about trying to combine business and pleasure. For example, if you're taking clients to a ball game on your husband's birthday, use extra care. Don't be surprised if the IRS or court asks if you had relatives at the business destination.
9. You can't deduct expenses for a spouse on a business trip unless he or she is employed by the business and there's a bona fide business reason for his or her presence.
10. Deductions for business gifts are limited. If you want to compensate workers with more than the $25 limit, you should generally pay the individuals or provide the gift and give them each a 1099 or W-2 (whichever is proper) for the value.
11. Business owners often have a more liberal view of business expenses than the IRS. If the dollars involved are significant, talk with an EHTC tax adviser about the rules.