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Why the IRS audits Schedule C's

February 29, 2012

A scary headline: "Freelance? An IRS audit may be in your future."

A Tax Court case yesterday shows why a Schedule C on your return might interest the tax man. A New York City taxpayer filed a Schedule C return for his "marketing" business showing no income, but $14,027 in expenses -- reducing his tax liability by $3,995.

The IRS took a closer look, and the Tax Court takes up the story:

The total expenses claimed in the 2007 Schedule C included claimed "Other expenses" of $12,294.4 Those "Other expenses" consisted of the following expenses that petitioner claimed for: (1) "Training costs" of $10,182, (2) "Telephone and internet" of $539, and (3) "Dues and Subscriptions" of $1,573.

Of the total "Training costs" of $10,182, $7,742 related to online course materials and online coaching materials, and the remaining $2,440 related to travel, meals, and lodging. Of the total "Telephone and internet" expenses of $539, $48.20, $50.20, and $133.73 were for expenses charged by "Domain names/Hosting", "Domains/Hosting SRVC", and "Domains/Hosting", respectively, and the remaining $306 was for expenses charged for petitioner's Time Warner Cable service.5 Of the total "Dues and Subscriptions" of $1,573, $335, $140, $53, $633, $44, and $215 were for expenses charged for mailbox rentals, Word Champion Edge "web and spkrs", Franklin Covey, periodicals, credit reports, and software, respectively.

Gee, it almost looks like he was claiming business deductions for personal expenses. The Tax Court didn't have to decide that; it just had to decide that he wasn't really trying to make money:

A taxpayer is entitled to deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. Sec. 162(a). In order for an activity of a taxpayer to constitute the carrying on by the taxpayer of a trade or business within the meaning of section 162(a), the taxpayer's primary purpose for carrying on the activity must be for income or profit...

Petitioner relies principally on his own testimony and certain documents that the parties stipulated (petitioner's documents) to establish his position that the "Other expenses" that he claimed in his 2007 Schedule C and that remain at issue satisfy all of the requirements of section 162(a) and therefore are deductible under that section. With respect to petitioner's testimony, we found it to be uncorroborated, self-serving, vague, general, and/or conclusory in certain material respects...

On the record before us, we find that petitioner has failed to carry his burden of showing for his taxable year 2007 that the primary purpose for any activities that he may have undertaken with respect to his claimed THJ marketing business was for income or profit, that he was involved in his claimed THJ marketing business with continuity and regularity, and that his claimed THJ marketing business was a going concern.

Early in my career another preparer told me that she made sure all of her clients had a Schedule C so they had a place to deduct personal expenses. That motive is behind many multi-level marketing Schedule C businesses. It's not that easy. The IRS over the decades has caught on, and money-losing Schedule C's, especially those with little or no top-line income, have become invitations for a visit from your neighborhood revenue agent.

Cite: Henderson, T.C. Memo 2012-54.

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