Here are some experiences of IRS audits collected by Tom Copeland. Readers should understand that IRS auditors may interpret tax laws differently and that the factual circumstances can vary widely from one case to another. The cases reported here are not precedent that must be followed by your local IRS auditor. However, the cases can be used to argue your position if you are audited. Sometimes cases are won by the side that is able to bring forward the most written case law and examples to support their position.
A provider in California was told by his auditor that he could not depreciate any portion of his furniture and appliances as business deductions because she owned these items before her business began. The auditor also disallowed business miles for field trips, saying they were not ordinary and necessary expenses. After discussing these and other issues with the Institute, the provider appealed the auditor’s decision to a hearing officer. The hearing officer allowed all of the disputed deductions. Afterwards the provider said, “My first thought after hearing the auditor’s decision was to pay up and get the audit over with. But then I decided I didn’t want to pay any more taxes than I really owed. Although it took 10 months to resolve, it was worth it. I saved over $8,500.”
In a Minnesota case, the auditor would not allow a provider to claim an exclusive business-use room because the provider’s own child played with the other children in the room during business hours and this created a personal use of the room. The child was not in the room after business hours. We argued on appeal that the test of whether or not a room could be claimed as 100% business use was how the room was used, not who used it. Because the provider’s child was participating solely in business activities while in the room, the room still should be considered in business use. The hearing officer agreed with our position. (We have sent copies of our written argument to tax preparers in two states, and these documents helped them to win their cases as well.) The auditor also denied the provider’s 100% deduction for a freezer and VCR because she didn’t believe that the provider only used these items for her business. We produced photos showing that the provider owned another freezer and VCR that were used for personal purposes. On appeal we argued that the provider’s testimony should be accepted because it was believable and because our proof was comprehensive; there were no other records we could show that would prove our position. The hearing officer agreed with us. Providers who are claiming 100% of any appliance or furniture should take pictures of similar items used personally. They should also make a note of how such items are used in their business.
A provider kept precise records on her computer of all business and personal trips made in her car. She only claimed as business trips those in which the primary purpose was business, based on the cost of the items purchased. The auditor said she could not claim a trip as a business trip if a personal item was purchased during the trip. We showed her a copy of a letter we received from the IRS a number of years ago that clearly states the standard definition of “primary purpose,” but the auditor would not change her mind. We appealed, but the auditor wrote us before the case was sent to the hearing officer and informed us that she would not contest it because she did not believe the IRS would win on appeal.
The auditor also would not allow the provider to claim any of the hours she worked on Saturday doing record keeping as part of her Time-Space percentage. She said that since children weren’t present on Saturday, her business was not open and no hours could be counted. Again, after we announced we would appeal, the auditor backed off and we won. Finally, the auditor said that the provider could not depreciate 60-80% of such equipment as a VCR, television, table, bookcase, and games unless the provider could produce some type of log showing exactly how she calculated this allocation of business use. The auditor would allow the provider to depreciate the furniture using her Time-Space percentage of 41%. Based on having nine children in her care and three children of her own, the provider had estimated conservatively that these items were used 60-80% of the time for business. But without a written record showing how she determined it was 60-80% business use, we lost this point. Normally, keeping a log showing business and personal use for a couple of months would have been enough to claim a higher business-use percent.
Another provider’s tax preparer had made the error of claiming 100% of her property tax, mortgage interest, and utilities on Schedule A and on Schedule C. As a result, the provider had to pay about $2,000 in taxes and interest. The auditor denied many business deductions because the provider only had canceled checks and notations in her Calendar-Keeper, but no receipts. One category of these expenses was toys. We had the provider take pictures of the toys to show that they were for preschoolers and were not used by the provider’s own 13-year-old son. The auditor still would not allow any of these deductions because she said they could have been used personally by her son. We argued that there is no law that required us to produce receipts and that our records should be accepted. We appealed and won all of the deductions denied by the auditor. Without receipts it took a long time to win this case.
The provider also claimed food expenses more than $1,900 in excess of what she received from the Food Program. She had only canceled checks for her business food expenses and very few records showing her personal food expenses. The auditor was willing to allow her to claim a food deduction equal to her Food Program reimbursement. We asked the provider to count up all the extra meals and snacks she served that year that were not reimbursed by the Food Program. We multiplied these meals by the reimbursement rate for that year and asked that this additional $700 be accepted as food expenses. The auditor agreed.
A provider sold her home in 1993 after using it for her business for five years. She had not claimed any depreciation on her home during that time. The auditor calculated how much depreciation the provider was entitled to claim for these five years and made the provider pay taxes and interest on this depreciation (about $2,000). There was nothing we could do about this. The auditor denied a variety of house expenses, including paint, carpets, appliances, VCR, a chair, and other household supplies. The auditor argued that the provider did not have receipts for every item. We were able to successfully argue on appeal that canceled checks and records from later years showed that these were normal household expenses.
Another Minnesota provider had hired her own three children to do work for the business. She paid them by check and made a notation on the check that it was for business work. The provider did not file any payroll forms, such as Form 941, Form W-2, or Form W-3. On appeal, we compromised and accepted one-half of the wages paid to her children. Without the proper records (payroll forms, job description, notations of when work was performed), it was difficult to argue for this deduction. The auditor also denied many of the hours the provider worked on activities such as record keeping, meal preparation, and cleaning. For nine months of the year the provider had kept a daily record of these work hours in her Calendar-Keeper. She was claiming a Time-Space percentage of 45%. We argued on that the provider had better records than most and that they should be accepted, regardless of whether or not the auditor thought it was too many business hours compared to other providers from other audits. The hearing officer quickly accepted all of these hours.
An auditor would not accept that a provider had an exclusive-use room for her business in 1993. The room was being remodeled at the time of the audit. The provider had one photo, taken in 1993 that showed only a small part of the room. The auditor sent letters to all the parents asking them if the provider used the room exclusively for her business. Four parents replied yes and two replied that they didn’t know.
We also submitted a video that was taken in the room in 1993 showing a Halloween party. The auditor said the video showed that a couch and TV were in the room and assumed these were used for personal purposes on weekends or evenings. We said this was not the case and produced photos of other TVs and couches that were for personal use. We won this issue on appeal. Providers should take pictures of exclusive-use rooms and write down how the rooms are used by their business.
Also, the provider bought a $4,000 piano and a $1,000 camcorder that she used 29% and 25% respectively for her business. The auditor didn’t believe that these were used in the business. We produced piano books that some children and the provider used, and we had parents write letters saying that their children did use the piano. We produced the video of the Halloween party to show that the camcorder was used in the business. We won both depreciation deductions on appeal. Finally, the provider installed a second phone line that she used for her business and claimed as a 100% business deduction. The auditor denied all of this deduction. We asked the provider to keep a log for several weeks showing how much the second phone was used for business. The log showed a 75% business use. The auditor still would not allow any deduction, saying that no deduction was allowed for a second phone line unless it was used 100% for business. We asked for written authority that supported this position. The auditor produced a congressional report that stated that a second phone could be deducted when used part for business purposes and part for personal purposes! Apparently the auditor did not realize that the report supported our position, not hers. The auditor wrote in her report to the hearing officer that a compromise position would be to allow 31% business deduction. We got a copy of her report through a Freedom of Information Act request. We compromised and accepted the 31% figure on appeal. It was easy to win this amount because we had already seen that the auditor was willing to accept this figure. The auditor also accepted additional food expenses above the Food Program reimbursement amount based on counting an additional afternoon snack that was not reimbursed. The provider had claimed much more as a food deduction, but we had a hard time arguing without having all her personal food receipts.