Taxpayers frequently have a sense that small details on their taxes can make a potentially huge difference regarding whether they will owe money or receive a tax refund. Unfortunately, people consider the possibility that missing small details like voluntary elections or keeping and maintaining sufficient tax records could result in the IRS making changes to your tax returns. Practically speaking, when the IRS makes changes to your taxes, it is rarely in your favor. Furthermore, if the IRS is seeking additional information, it may be to probe for the possibility that you failed to keep records or take actions that would justify the tax position.
In particular, taxpayers who make claims for tax benefits on the basis of status as a real estate professional are particularly vulnerable to IRS audit and examination tactics. Taxpayers intending to claim real estate professional status and associated tax benefits should engage with a tax professional to minimize the likelihood of facing an audit that results in the imposition of a significant tax burden
In Zarrinnegar: Despite Having a Valid Dental Practice, Insufficient Records Meant Most Deductions Were Disallowed and a Negligence Penalty was Imposed
In Zarrinnegar v. Commissioner, the taxpayers were married and filed joint taxes. They both worked as dentists. The husband also managed a real estate brokerage with activities involving four rental properties. Only the husband was engaged in the real estate business. The wife did not engage in any real estate activity. According to the facts set forth during the proceedings, the husband spent over 1,000 hours annually working on real estate business activities.
Through their joint federal tax returns, the taxpayers filed taxes for 2010, 2011, and 2012 tax years. The IRS issued deficiency notices for each year. These deficiency notices were issued to disallowed deductions for the losses reported on petitioners’ Schedules E. Deductions involved supplies purchased allegedly for the dental practice.
Complications existed because many of the dental practice records had become unreadable due to water damage and faded ink. Generally, the court noted that “Apart from petitioner husband’s vague and general testimony, petitioners did not offer any evidence to show what items were purchased or how they related to petitioners’ dental practice.” Therefore, a substantial amount of their office expenses and general expense deduction disallowances were sustained.
Because the taxpayers could not justify many of the overstated deductions in any real sense, the IRS also sought a tax negligence penalty under IRC Section 6662(a) and 6662(b)(1). Under the statute, a taxpayer can face an additional tax penalty of 20 percent on any underpayment of tax attributable to negligence or disregard of the rules or regulations. Negligence includes any failure by the taxpayer or taxpayers to make a reasonable attempt to comply with the provisions of the Internal Revenue Code, and “disregard’ [of rules or regulations] includes any careless, reckless, or intentional disregard.”
Because taxpayer’s records were largely destroyed due to water damage and the credit card receipts did not substantiate many of the taxpayer’s claimed deductions, the court imposed the “section 6662(a) penalties with respect to the underpayments attributable to petitioners’ overstatement of deductions.” Since the taxpayers lacked these records, they were also unable to show that their compliance failures were “reasonable” or that they acted in “good faith.”
In Stark Contrast, Taxpayers Pull of Rare Escape with Real Estate Professional Loss Deductions Intact Due to Sufficient Records and Evidence
In addition, there was a question regarding the propriety of deductions for rental losses. As for the real estate rental loss deduction, passive losses cannot typically be deducted in the current tax year. Generally, losses from rental activities are assumed to be passive losses, subject to certain exceptions. However, real estate professionals may nevertheless deduct real estate losses if he or she engaged in material participation such that the material participation requirement is satisfied.
Per section 469(c)(7)(B), a taxpayer may claim to be a real estate professional when:
more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
Thus, an individual’s real estate activities make-up greater than one-half of his or her work for the year. In addition, the individual must perform greater than 750 hours (roughly 14.4 hours per week) of material participation in real-estate activities. The material participation aspect of the test can be met when any of seven tests is met including: “The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year.” Since the IRS conceded that the husband’s activities met the standard set forth in this part of the material participation rule, the remaining question is whether the taxpayer’s evidence could show that he worked at least 750 hours as a real estate professional and this activity constituted more than half of the taxpayer’s personal services performed for the year.
In making this showing, a taxpayer can do so by “reasonable means.” Reasonable means can include business records kept in the regular course of business, appointment books, calendars, and recollections in support of the foregoing. Unlike the records kept by the taxpayers for the business deductions, the taxpayers’ hourly logs for hours worked at the dental practice and real estate business was intact.
The taxpayers presented the business hour logs for 2010, 2011, and 2012 testifying that they were prepared contemporaneously. The content of the logs and additional testimony showed that the taxpayer did indeed satisfy the 750-hour portion of the test working in excess of 1,000 hours annually at the real estate business. The taxpayer was also determined to have satisfied the second part of the test since he worked only about 728 hours a year at the dental practice. The court, therefore, concluded that the husband’s participation in real estate activities for 2010, 2011, and 2012 meets the test in 469(c)(7)(B) thereby making the real estate loss deductions permissible.
Keeping and Maintaining Records Is Often the Key to Prevailing in a Tax Appeal
However, it is extremely easy to see this the court reaching an opposite determination on the rental loss issue. Consider, for a moment, if the water damage had also extended to the hourly logs. If the hourly logs were also destroyed, then the taxpayers would have faced a factual scenario similar to the disallowed business expenses. In fact, the court specifically notes that relevant precedent holds that, “A post-event ‘ballpark guesstimate’ is not sufficient.” Moss v. Commissioner, T.C. 365, 369 (2010).
Had the hourly records been rendered illegible, the taxpayer would have lacked any contemporaneous records. Therefore, the taxpayers would have merely been able to provide testimony of their recollection of hours worked that most courts would characterize as “self-serving” and contrary to Moss.
When a court lacks testimony or evidence that it finds “credible,” it often has no choice but to disallow the deduction or take other adverse action against a taxpayer. Taxpayers who handle their taxes themselves are more likely to fail to recognize just how important keeping sound business records is. As one can see in this matter, one’s record-keeping abilities (and the luck or foresight to avoid damage to the records) can make the difference between sustaining a deduction and facing disallowed tax deductions and additional tax penalties due to negligence.
Business Tax Questions?
Small errors in process, planning, or approach to taxes can result in big problems for taxpayers. The tax lawyers and tax professionals at the Tax Law Offices of David W. Klasing can assist with all aspects of business tax planning, compliance and civil / criminal tax controversy. If your business has come under audit or if you are facing questions about deductions and tax positions, we also may be able to help. To better understand why you should hire a tax attorney for tax audit representation, please see this video and others on our Los Angeles Tax Attorney YouTube Channel. If you are ready to see if our tax services are right for your business, call our Los Angeles or Irvine tax law offices at 800-681-1295 for a reduced rate intital consultation.
