Taxpayer fails to show profit motive
Jerald worked full-time at Turbine Traders Ltd. as a marketing and sales representative. His main job was selling parts and services for helicopter engines. He earned $132,000 a year in wages.
Jerald has owned interests in and has raced horses for more than 20 years. He purchased his first race horse in 1987 when his nephew’s friends invited him to co-own a race horse with them. After successfully racing this horse, they purchased another horse for $100,000 where Jerald owned a 10% interest. That horse won a race in San Diego, and they sold the horse for $200,000.
In 2001, Jerald purchased a five-acre property in Ravensdale, WA for $650,000, where he lived with his roommate. The property included a barn with horse stalls, an arena, various outdoor shelters and nine pastures. Several improvements had been made to the property over the years, and in 2015 it had an appraised value of $919,228.
During the years at issue, Jerald used the Ravensdale property to board his horses when they were not racing. Additionally, his roommate paid $6,000 a year rent for using the property for his own business of training show horses, boarding the horses he trained and teaching horse-training clinics. Beginning in 2007, Jerald waived his roommate’s rent in exchange for a reduced rate on supplies and care for the horses Jerald owned.
There were three or four horses in which Jerald owned an interest that were actively racing at two racetracks. These horses were housed and trained at the racetracks for the season. Jerald spent time researching race horses on the Internet, including horses he used to own and horses he was interested in purchasing. On the weekends, he cleaned stalls and pastures, attended races at the racetracks, helped his roommate care for the horses and watched videos of the races during the evenings. Jerald engaged in these activities throughout the entire year.
After purchasing the Ravensdale ranch, Jerald adjusted his work schedule at Turbine Traders, Ltd. to spend more time on his horses. He loves horses and enjoys betting on the races. He watches all the races in which his horses participate, and reports his gambling winnings separately on his federal income tax return as gambling income.
Over the years, some of Jerald’s horses did win. Purses ranged between $8,000 and $25,000, though occasionally a purse would bring in $50,000. When a horse’s racing career was over, Jerald and the other co-owners would either give the horse away or sell it.
Despite some racing success, Jerald’s horse-racing activity resulted in a loss every year. His average loss from 2005-2014 was $62,422. He also reported gains and losses for selling his interests in the race horses and horse-racing equipment.
He kept the income and expenses for each horse in a manila folder with the horse’s name on the outside. Jerald never created a formal written business plan, annual budgets or profit and loss projections for his horse-racing activity. From 2005-2014, Jerald sold interests in 36 horses but realized a gain on only eight of those sales.
He had a personal bank account and a horse-racing bank account but paid expenses for the horse-racing activity out of both accounts. He used his wages from Turbine Traders Ltd. to fund his horse-racing activity. He also took money from his pension and IRA accounts during these years to fund this activity.
Jerald hired an accounting firm specializing in horse racing to prepare his federal income tax returns. They sent him a worksheet detailing expenses he may have paid in that year and asked him to fill out and return it so the accountant could prepare his return.
The IRS determined the horse racing activity was not-for-profit based on the following:
- Manner in which activity is conducted. Jerald maintained that he operated the horse-racing activity in a businesslike manner since he kept accurate books and records. The IRS argued that although he kept records he did not implement any methods for controlling losses, including efforts to reduce expenses and generate more income. This factor favors the IRS.
Taxpayer’s time and effort to carry on activity. The IRS contends that Jerald’s time and effort spent on his horse-racing activity was limited by his full-time employment. Although Jerald was employed full-time while conducting the horse-racing activity, he: (1) used the Internet to check horses’ past performances, research horses that were racing on upcoming weekends and research horses he was interested in purchasing; (2) altered his work schedule at Turbine Traders to accommodate his horse-racing activity; and (3) performed menial tasks, such as cleaning the barn stalls and picking up horse manure on the weekends. The IRS accepted these factors, which weighed in favor of a profit objective for Jerald.
- Taxpayer’s success in other activities. There was no evidence Jerald was involved in any other successful business enterprises as an owner or operator. This factor is neutral at best.
- History of income and losses for the activity. Jerald realized no profits in more than 20 years of engaging in his horse-racing activity. He argued that he suffered losses because he reinvested his gross receipts back into the horse-racing activity and used the money to improve the barns, arena and other horse-racing activity property. This did not justify or even explain the unbroken string of losses over 20 years. This factor favors the IRS. Amount of occasional profits for the activity. Jerald started to have success from one horse, Dare Me Devil, where in 2014 and 2015 he thought he might be profitable. This speculation of possible profitability does not outweigh the 20 years of losses. This factor favors the IRS.
Taxpayer’s financial status. Jerald did not earn substantial income from his horse-racing activity to pay basic living expenses. He took out retirement income of $48,000, $25,000 and $25,000 between 2010 and 2012. The racing activity generated tax savings by creating losses to offset this other income. This factor favors the IRS.
Expectation that assets may appreciate. Although the Ravensdale property has increased in value over the past years, there is no evidence in the record that the expectation of future appreciation of the Ravensdale property even begins to approach the amount of losses Jerald has reported since beginning his horse-racing activity. This factor is neutral. The expertise of the taxpayer and his advisors for this activity. Jerald presented no evidence that he conducted a basic investigation of the potential profitability of his horse-racing business. He did not show he consulted with any experts in the field on how to run a profitable horse racing business. He did not use his accounting records to cut expenses or increase income to become profitable. This factor favors the IRS.
After considering all these facts and circumstances, the IRS concluded that Jerald did not engage in his horse-racing activity during the years at issue with the predominant, primary or principal objective of making a profit independent of the tax savings. The IRS determined that his horse-racing activity was a not-for-profit activity, limiting the losses to the extent of income.
Tax Pro Monthly Issue 8 Vol. 39 August 2017
New overtime option? Under a new bill proposed in the House, employers can offer to reward employees with extra time off in lieu of receiving pay at the usual time-and-a-half overtime rate. The choice would be voluntary. Any unused compensatory time at the end of a year would be converted to overtime pay.
Small Business Tax Strategies Vol. 12 No. 7 July 2017
S corporation owners can only deduct losses up to the amount of their basis in the shares. But some business owners ignore this limit, much to the chagrin of the IRS. Now the tax collection agency’s Large Business and International Division is ramping up audits in this area. Its agents will contact shareholders to ensure they are properly limiting their losses to their stock basis.
Small Business Tax Strategies Vol 12. No. 7 July 2017
Fantasy sports is sweeping the nation. It can range from casual leagues just for fun to
heavy betting for high stakes.
Strategy: Learn the tax consequences. If you don’t, you could land in hot water with the IRS.
Although the tax law is still evolving, fantasy sports is generally treated as a form of gambling where payoffs are concerned.
Here’s the whole story: To play fantasy sports, you might sign up with an online forum like FanDuel or DraftKings offering winnings based on daily, weekly or season-long performance; or enter into a league of friends or family hosted by websites such as Yahoo and ESPN. Virtually all athletic pursuits are represented.
If you play fantasy sports for money and win, however, the IRS is going to want to get its share. Fantasy sports websites are legally obligated to report annual winnings of $600 or more on Form 1099-MISC. You get a copy of the form, and so does the IRS. So the IRS knows how much you won. If you’re paid through a third-party source (e.g., PayPal), you’ll likely receive a 1009-K instead.
Don’t think that this is being shoved under the rug. IRS computers may flag discrepancies if you don’t report 1099 income on your return. Typically, a fantasy sports entity will calculate your “net profit” as being equal to the amount of your winnings minus entry fee plus any bonuses. For instance, if you hit the jackpot this year with a $25,000 payout and a $5,000 bonus and it cost you a $1,000 entry fee, your net profit is $29,000.
This income should be reported on your 1040 along with other random income like jury duty pay and trustee fees. At least there’s a silver tax lining: Income from gambling activities can be offset by gambling losses, but only up to the amount of your winnings. Thus, if you have losses elsewhere, you might break even taxwise.
In this brief analysis, we’ve presented a general tax outline for casual players. If you’re in the “business” of playing fantasy sports, you’re treated like a professional gambler who can deduct losses on Schedule C. To support your position, you may have to prove that the activity isn’t a hobby, based on nine factors listed in IRS regulations. Notably, you must show that you legitimately intended to turn a profit and generally acted in a business-like manner.
Tip: State laws will govern income taxation on the state level.
Small Business Tax Strategies Vol. 12 No. 7 July 2017
Did the IRS just signal the end of Obamacare? Under the Affordable Care Act (ACA), supported by President Obama, the agency would reject tax returns if taxpayers indicated that they didn’t have qualified health insurance, unless they were exempted. If Line 61 of Form 1040 was left silent, the return was to be rejected. The reason: Nonexempt individuals without qualifying coverage would owe a penalty. Now the IRS says that it will process returns whether there’s an entry on Line 61 or not.
Small Business Tax Strategies Vol. 12 No. 4 April 2017
|Here’s what happens. The IRS Automated Underreporter Unit (AUR) matches income reported on individual tax returns with the income that is reported to the IRS from various third parties (e.g., employers, financial institutions, and banks) and recorded in its wage and income transcript file.|
If there is a difference, the IRS “flags” the tax return for further review and may issue a CP2000 Notice. The notice tells the taxpayer that there are proposed tax changes because of a mismatch between the income shown on their return and the income reported to the IRS. It is worth noting that the IRS system does not work in real-time but rather runs in a batch mode.
There are two kinds of individual tax AUR notices:
- A “hard” CP2000, which shows proposed changes and additional tax due
- A “soft” CP2501, which asks for clarification regarding missing income items
Both require a response, although the CP2501 requests it far more politely.
The business versions of the CP2000/CP2501 are the CP2030/CP2531. IRS Publication 5181 is a great reference on CP2000/CP2030 Notices.
These notices are a fact of life because our taxpayers do not always present us with all their income documents when we are preparing their tax returns. In fact, in recent years, the IRS AUR has sent out over 4 million CP2000 Notices.’
Typical reasons run the gamut and include:
- “I didn’t tell you about the inherited U.S. savings bonds I cashed in because my hairdresser told me they were tax-free:’
- “I didn’t tell you about my Roth IRA distribution because it is tax-free:’ (Roth distributions are fully taxable if they are not shown on the tax return. The taxpayer must prove basis to prove they are not taxable. However, they could be subject to a penalty)
- “I moved and didn’t get my 1099-R for my $50,000 early distribution:’
- “I exercised my non-qualified stock options (Code V in Box 12 of the W-2) and paid normal income tax on the gain. TurboTax did not prompt me to enter the sale on Schedule D:’
As we say in the trade, you can’t make this stuff up!
A return flagged for unreported income can still be subject to examination at a later date. When a taxpayer gets a CP2000 Notice, they often think they are being “audited?’ It is important
to help the taxpayer understand exactly what the notice means and what his or her response options are.
Possible CP2000/CP2501 responses include:
- No response, in which case the proposed tax will be assessed
- Respond and agree
- Respond and disagree
- Respond and disagree, providing compelling documentation as well as background information in an attempt to reduce or eliminate the penalties associated with any increased tax.
Taxpayers have 60 days from the date of notice to respond to the CP2000/CP2501. The notice actually says 30 days, but it provides for 60 days if the taxpayer is out of the country. Since the IRS doesn’t know whether or not someone is out of the country, 60 days has become the standard.
I have gotten involved in responding to CP2000 Notices after the Notice of Deficiency was issued (I have faxed a response to the AUR Group on the 30th day of the 90-day
NOD and received a No Change on the 85th day). If no response is received after a late “hail Mary” fax, the taxpayer can still file a pro se petition to the Tax Court and continue to work on resolution while the case makes its way through docketing and appeals.
IRS Wage and Income Transcript Database Development
The IRS wage and income transcript database begins to populate after the tax year is over. For example, 2015 wage and income data were added to this database throughout calendar year 2016. In early 2017, the database will be complete, and the IRS will run its return-matching program against the database. The 12 months required for the database to be developed is the reason for the substantial delay between filing a return and getting a notice.
When the IRS runs its matching program, it flags returns showing a mismatch with Transcript Code 922, Unreported Income. This should occur in February and March 2017 for the 2015 tax year.
2015 PATH Act Changes
In an effort to reduce tax identity theft, the new deadline for filing W-2s and 1099-MISC with Box 7 NEC (non-employee compensation) has been moved up to January 31. This will allow the IRS to verify that the income reported on 2016 returns “matches” the income reported to the IRS prior to sending out refunds with refundable credits.
It is not clear how this new W-2 program will affect the AUR matching program and its associated CP2000 Notices. Stay tuned.
Strategies for Preventing
The way to prevent a CP2000 Notice is to report all income properly. Since our clients exercise some judgement on the tax documents they present to us, we can’t depend on the information we receive from them to be complete. Here are a few strategies we can use to at least reduce the frequency of CP2000 Notices.
File an extension and verify income. Some of us work with troubled taxpayers (procrastinators) and have a Form 2848 or 8821 in place for each of our clients. We create a preliminary tax return prior to April 15 and ask our taxpayers to send in the preliminary balance with their extension.
In the August/September timeframe, we pull the IRS wage and income transcripts and verify that we have accounted for all the income reported to the IRS. Occasionally, I have seen new income documents hit the IRS transcripts as late as early October. Following this extension-and-verify-income procedure generally will reduce or eliminate CP2000 Notices.
Duplicate the IRS AUR procedure. A great strategy to check for an income-return mismatch is to duplicate the IRS AUR procedure. Late in the year, pull the wage and income transcripts from the previous year on each return we prepared and look for differences between reported income and the tax return.
This is a lot of work, but it can be simplified with the wage and income summary, a one-page summary of all the income items. Typically, you will have a Form 8821 or 2848 on each client, so you can easily pull transcripts via IRS e-Services using commercially available software.
Catch the error before the IRS does. Take advantage of the IRS matching process and do your own search for the Code 922 Unreported Income in the IRS account transcripts in the February to March 2017 timeframe. The IRS has done the heavy lifting; you just look at the results.
When you do so, you can verify the mismatch between the filed return and the IRS wage and income transcript; if there is an error or omission, you can amend the return months before the AUR CP2000 Notice is mailed to your client. This saves the embarrassment of your client receiving an IRS notice (they hate that) and avoids having to pay some interest and the ever-possible 20 percent penalty (accuracy-related or substantial understatement of tax).
Monitoring these transcripts has an interesting benefit. The IRS is flagging income that was left off the return—but if the omitted income results in a refund, it appears to be current IRS policy to not send a CP2000 Notice. I have seen two of these in the past several years and have filed amended returns for refunds (a W-2 with high withholding was omitted from the return).
The policy of many tax professionals is to cover penalties and interest if they make an error; detecting and correcting these errors early saves the cost of penalties and reduces the potential interest.
Understanding the IRS
Matching Program Process
If the IRS Matching Program detects unreported income, a Code 922 is placed in the account transcript with the corresponding date. Typically, the transcript will appear as:
When the IRS sends a notice to the taxpayer, the date is changed to match the date on the CP2000 Notice. Typically, the transcript will be updated to:
With each ensuing IRS letter, the date of the 922 code on the transcript will be updated to the date on the most recent letter. If no response is received, the final letter will be a CP3219A Notice of
Deficiency (commonly known as the 90-day letter). If no response is received after the CP3219A is issued, the tax determination is final, and the additional tax due is posted to the account transcript. If the taxpayer later wants to contest the assessed tax, they can submit an Audit Reconsideration request with supporting documentation to attempt to get the tax reduced to the correct amount.
In 2014, the AUR unit ran the matching program several times throughout the year. By observation, it appears that IRS budget cuts have reduced the number of matching runs. The IRS could increase the frequency of its computer-matching runs, since the majority of the data is available sooner.
If you are monitoring the account transcripts to check on AUR unreported income, it is prudent to pull the account transcripts every two weeks using commercially available software to continuously check on the status of each account. This strategy has the additional benefit of scanning for returns that have been flagged for examination (Code 420). The time between a return being flagged for exam and the actual exam letter has been observed to be as long as 18 months.
If a return is flagged for exam, you can review the return and, in some cases, offer an amended return to self-correct the issue that appeared to cause the exam flag. We have seen cases where the audit was short-circuited and the IRS accepted the changes on the amended return with no further correspondence.
In this time of budget constraints, we have also seen a timely filed 2012 return flagged for exam in late 2014 (Code 420), and seven months later saw a code 421 Exam Closed with no letters sent to the taxpayer and the Power of Attorney (POA). It appears that the audit would have to begin with less than 12 months remaining on the three-year audit statute—IRS policy is to have more than a year remaining on the statute before an exam is initiated. When an audit flag is detected on a prior year return, the current year return should be prepared with the expectation of an audit. All items should have documentation to back up every number on the current year return.
This all may sound like a lot of work, but it’s what we do. Enrolled agents are the go-to tax professionals when it comes to pulling and analyzing IRS transcripts to monitor and protect our clients.
EA Journal Vol. 35 No. 2 March/April 2017
My accountant says my state income tax refund from last year is taxable. Is this possible? H.C., Middlesex, N.J.
Yes. If you claimed state income taxes as an itemized deduction on Schedule A of your 2015 Form 1040, any refund you received in 2016 from the state counts as taxable income on your 2016 return. In essence, you can’t have things both ways if you deducted the full amount that you paid. However, in other cases, the refund isn’t taxable. For instance, this rule doesn’t apply if you deducted state sales taxes instead of income taxes on your 2015 return.
Tip: There’s no tax on a refund received for a year for which you claimed the standard deduction.
Small Business Tax Strategies Vol. 12 No. 4 April 2017
Farms include ranches, ranges and orchards. Some raise livestock, poultry or fish. Others grow fruits or vegetables. Individuals report their farm income on Schedule F, Profit or Loss from Farming. If you own a farm, here are some tips to help at tax time:
Crop insurance. Insurance payments from crop damage count as income. Generally, you should report these payments in the year you get them.
Sale of items purchased for resale. If you sold livestock or items that you bought for resale, you must report the sale. Your profit or loss is the difference between your selling price and your basis in the item. Basis is usually the cost of the item. Your cost may also include other amounts you paid such as sales tax and freight.
Weather-related sales. Bad weather such as a drought or flood may force you to sell more livestock than you normally would in a year. If so, you may be able to delay reporting a gain from the sale of the extra animals.
Farm expenses. Farmers can deduct ordinary and necessary expenses they paid for their business. An ordinary expense is a common and accepted cost for that type of business. A necessary expense means a cost that is proper for that business.
Employee wages. You can deduct reasonable wages you paid to your farm’s full and part-time workers. You must withhold Social Security, Medicare and income taxes from their wages.
Loan repayment. You can only deduct the interest you paid on a loan if the loan is used for your farming business. You can’t deduct interest you paid on a loan that you used for personal expenses.
Net operating losses. If your expenses are more than income for the year, you may have a net operating loss. You can carry that loss over to other years and deduct it. You may get a refund of part or all of the income tax you paid in prior years. You may also be able to lower your tax in future years.
Farm income averaging. You may be able to average some or all of the current year’s farm income by spreading it out over the past three years. This may cut your taxes if your farm income is high in the current year and low in one or more of the past three years.
Tax credit or refund. You may be able to claim a tax credit or refund of excise taxes you paid on fuel used on your farm for farming purposes.
When you give a gift to charity that helps the lives of others in need. It may also help you at tax time. You may be able to claim the gift as a deduction that may lower your tax. Here are eight tax tips you should know about deducting your gifts to charity:
Qualified Charities. You must donate to a qualified charity if you want to deduct the gift. You can’t deduct gifts to individuals, political organizations or candidates. To check the status of a charity, use the IRS Select Check tool.
Itemized Deduction. To deduct your contributions, you must file Form 1040 and itemize deductions.
Benefit in Return. If you get something in return for your donation, your deduction is limited. You can only deduct the amount of your gift that is more than the value of what you got in return. Examples of benefits include merchandise, meals, tickets to an event or other goods and services.
Donated Property. If you gave property instead of cash, the deduction is usually that item’s fair market value. Fair market value is generally the price you would get if you sold the property on the open market.
Clothing and Household Items. Used clothing and household items must be in at least good condition to be deductible in most cases. Special rules apply to cars, boats and other types of property donations.
Form 8283. You must file Form 8283, Noncash Charitable Contributions, if your deduction for all noncash gifts is more than $500 for the year.
Records to Keep. You must keep records to prove the amount of the contributions you made during the year. The kind of records you must keep depends on the amount and type of your donation. For example, you must have a written record of any cash you donate, regardless of the amount, in order to claim a deduction. For more about what records to keep refer to Publication 526.
Donations of $250 or More. To claim a deduction for donated cash or goods of $250 or more, you must have a written statement from the charity. It must show the amount of the donation and a description of any property given. It must also say whether the organization provided any goods or services in exchange for the gift.