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IRS Audit! Business and Rental
Organize your paperwork. Try to get everything into the same category as on the tax return. Audits go faster and more pleasantly when you can hand over what the auditor asks for without fumbling or excuses.
Don't have any of your records? It isn't a slam dunk that you've lost the audit. But you'll want to reconstruct as much as possible, and you'll want a CPA or Enrolled Agent that knows some tax law and relevant court cases.
Schedule C - Your small business
Receipts, canceled checks, invoices, bank statements, log books, even annotated calendars – these provide proof of income and expenses. Be prepared to discuss your method of bookkeeping (Do you record income and expenses as you receive / pay them? Do you have an inventory?) If your business has been losing money for several years, there will be questions about why you're still doing this and what you're doing to turn a profit in the future. There may also be questions about what other sources of income you live on, if this business isn't profitable. Don't be embarrassed to mention gifts from family or credit card debt you've run up, but be ready to provide proof.
Office in home. When you do a significant amount of work from home, or use an area exclusively for business storage, you might be able to write off a percentage of your house's expenses on Form 8829. Photos of the work area, preferably not showing the TV set or the vacuum cleaner, help to show that you meet the “regular and exclusive” tests. Open the closet door before taking the picture, and showing the contents of the filing cabinet may strengthen your claim.
Subcontract labor. If you paid someone as subcontract labor, you're required to issue 1099-MISC forms if the amount was over $600. For recordkeeping, many businesses issue 1099-MISCs for any amount paid to subs. Bring copies of these. Employee versus subcontract labor is an important distinction and the auditor may ask questions about how work gets done.
Auto expenses. Mileage expenses have to be recorded somehow, kept in a legible format that shows where you went, when, and the business purpose of the travel, whether handwritten or on a computer. This log is supposed to be kept whether you claimed the standard mileage rates or actual expenses. If you claimed actual expenses, you will need receipts too. The IRS will consider reconstructions using calendars and receipts showing that you had allowable travel, but may pursue it further to show that the travel was directly related to income or future sales.
Utilities. A cell phone is not automatically a business deduction, since everyone now carries one. If you can show that you had to upgrade your plan, or show your advertising that lists the cell number, you have an argument for some or all of your cell bill. Internet access is also widely used for personal reasons. If your primary income is from website sales, or you are a programmer, you're in a stronger position to get this deduction. Pull screen shots of your website and save these with your other tax information.
Opening a new business?
Before you open a new business, you often incur expenses. These could include travel, training, website development, licenses, and more. The IRS won't let you deduct them until your business is actually a going concern. They're called "start up expenses" and there are rules about how you handle them. Unlike most other expenses of a business, they can have been paid in a previous year. If the total of your start up expenses is less than $5,000, you can generally deduct them all. Call them "start up expenses" and show them on the "Other expenses" line of your Schedule C. If the total is between $5,000 and $50,000, you can deduct the first five thousand and amortize the remainder over 180 months (15 years). If the total goes over $50,000, you have to amortize it all.
A brand-new Schedule C business with no income may get audited solely because you were deducting your start up expenses too soon.
Schedule E - Rental and Passive
Proving income and expenses, obviously, is important. You may be asked if your tenant(s) pay by cash or check. If you routinely deposit rent into your bank account, rather than taking the cash and running, the trail is easier for the IRS to confirm.
Depreciation. One of your allowable expenses is the using-up of the building. The auditor will ask how you determined your cost. If you have the original closing statement, bring a copy. Major improvements and capital assets like HVAC or furniture are also depreciable. The auditor will want to see the depreciation schedule or calculation. Be prepared to discuss the items you wrote off under the Tangible Property Regulations, if you elected to do so.
Maintenance. The IRS was going to require landlords to issue Form 1099-MISC to subcontractors like the guy who mows the lawn. This has been postponed, probably indefinitely. If you did issue them, bring copies.
Mortgage Interest and Property Taxes. The IRS has copies of the Form 1098, which now shows the address of the mortgaged property. Don't assume the IRS knows which mortgage goes with business property. Bring your copy of the statement. It may also show the taxes. If not, bring proof of payment.
Repairs. Large repairs might be reclassified as capital assets. The rule of a repair is that it returns the property to a previous condition. Improvements that extend the life of the property or that make it more desirable have to be depreciated rather than written off. An example is a window -- if you call a glazier to replace the window pane, it's a repair. Noting that the window frame is rotting and installing a whole new window is a depreciable improvement. Taking too long to make repairs may cause the auditor to say that the property was not "available to rent" and so not eligible for deduction of expenses. "Too long" is IRS-speak for over a year, and handyman landlords who work when they can get around to it can easily take over a year.
Losses on Schedule E can be limited by the passive activity rules. The losses then carry forward until you're able to claim them or until you sell the entire passive activity, whichever comes first. The auditor will make sure you aren't claiming excessive losses. Most tax preparation software handles the limitation for you.
If you have income or losses on page 2 of Schedule E, bring along a copy of the Schedule K-1. You are not expected to bring a partnership or corporate tax return, unless you are the sole or primary owner.
You'll be asked whether you use the property personally, or allow family members to use it while paying less than a reasonable market rent. If you do, you'll find your expenses divided between "business" and "personal," with the apportioned personal amounts being non-deductible. This comes up most often if you have a place in a resort area like the mountains or at the beach.
Is It Even a Rental?
If you rent your property out for less than 15 days in the year, you don't have to report the income at all! You are also not allowed to deduct the expenses -- so a large write-off can't be created by renting your vacation condo for a couple weeks a year. I've heard this called the Mardi Gras rule, from the folks in New Orleans who rent out their homes for a week or two around the festival.
- How the IRS Views Business Losses versus Hobby Losses
- Funny Tax Deductions and Weird Tax Write Offs
The IRS may not have a sense of humor, but they have dealt with some funny, weird and surprising tax deductions. See which ones were denied and which surprising deductions were allowed by the IRS.
A Word of Advice
Small business and at-home business owners often find that the receipts they save fade over time. Since it takes the IRS one to two years to initiate an audit, your supporting documents may be blank paper by the time you need them. Photocopy or scan your receipts regularly.