Q-1:

Subject: Question for your blog

Hi Kerry,

 

Thanks for the wonderful information and insights on your website.  I have a question about an issue that's been worrying me, and everyone I ask gives me a different answer:

 

I'm a Schedule C filer who bought a home (which has since been sold) a few years ago.  The mortgage was a "stated income" loan, and apparently no verification of any data was done.  Several months ago, when I was preparing to sell the house, I discovered that the loan officer had grossly overstated my income, years on the job, and self-employment status, vs. what I had told her.  I never filled out a paper application - it was a face-to-face interview with her typing things into a computer.  The house is sold, that loan is paid off, and it has not been a problem.

 

Now, if I were to be audited, how likely is it that the auditor would request a copy of that loan application?  When they see an income listed that's several times the actual figure, what is likely to happen?  Is there anything I can do at this point?  I have asked a tax lawyer who seemed to think I was just paranoid and auditors never ask for loan documents.  I'm not sure sure about that.  The "imaginary income" listed on that loan application for the 5 "imaginary years on the job" is in excess of $280,000 - money I never made for a job I never had.

 

Again, thank you - maybe there are others out there in a similar situation that you've encountered....

A-1:

I wouldn't lose any sleep over that loan app causing you problems with IRS.

While I have never had an IRS auditor demand copies of loan apps, I have heard of that happening in extreme cases where the taxpayer was very uncooperative and had been living a lifestyle that cost more than the level of income being reported. 

The most important thing is to be able to account for all of your bank deposits because IRS auditors will spend a great deal of time trying to match the total for the year to the gross income you reported on your 1040.

I hope this eases your mind.

Kerry Kerstetter

Q-2:

Kerry,

 

Thank you so much.  I do feel much better about this now.  Hopefully my one-bedroom apartment and 1987 Volvo with 300,000 miles would indicate to an auditor that I haven't been living the high life... :)

 

Actually, regarding those bank deposits-  when I got started in my business (retail) a few years ago, I tried it for a few months, lost money, and quit, but started again the next year.  I unwisely didn't claim the loss that first year, since it was only a few hundred dollars.  I understand that an auditor would see the bank deposits for my business receipts and would add that amount to my taxable income.  I have complete receipts/documentation for all of my expenses (mostly cost of goods sold) that first year.  Is this a situation in which I might be able to show, after the fact, that I had a loss and still avoid tax, or would all of my expenses be disallowed since I didn't file a Schedule C that year?

 

With warmest regards,

A-2:

I don't intend to be overly harsh here, but your case is a classic illustration of how foolish it is to try to save a few hundred dollars by not using a professional tax preparer, and in the end costing yourself thousands of dollars in missed deductions and unwittingly breaking the law and putting yourself at risk for penalties related to that.  Ignorance of the law is no excuse, and all of that.

Trying to handle this on your own, you fell for at least two of the commonly misunderstood aspects of tax law; both of which any competent tax pro could have corrected for you.

Myth #1:  "Business losses don't need to be reported."  Whether you had a net loss or not, all business related gross revenue is required to be reported on your 1040.  As I mentioned last time, IRS auditors will spend a majority of their time analyzing the deposits on your bank statements and trying to match the annual total amount deposited to the gross revenues reported on your 1040.  If the bank deposits total more than what is reported on your 1040, the auditor begins from the premise that the difference is unreported taxable income and you are then forced to prove otherwise. 

For example, your business could have grossed $100,000 in sales and had $200,000 of perfectly legitimate business expenses.  You may think you are doing the government a favor by not claiming that loss by not showing anything regarding it on your tax return.  When the auditor discovers the unreported $100,000 of sales, s/he will assess taxes, penalties and interest on that amount of unreported income, which could very easily be as much as 75% ($75,000) all together. 

IRS auditors do not go through your records looking for unclaimed deductions.  Those are your responsibility to report on your 1040.  I'm not saying it would be impossible to offset the unreported income during the audit with deductions that you failed to show on your 1040; but it would definitely be much more difficult (tight documentation for each and every expense) than if you had reported them on the original 1040.

Myth #2:  "If the business expenses exceed the revenues, that's good enough and there is no benefit to showing it."  Not true!  Losses from a Schedule C business can shelter other kinds of income on the same 1040, such as from W-2s.  If there is still a negative AGI, the net operating loss (NOL) can be carried backward to previous years or forward to future years to reduce those taxes.  It's essentially a form of income averaging, a very useful tax break since our rulers killed the real income averaging back in 1986 because it saved people too much in taxes. 


I am in no way intending to advise you on how to proceed from this point.  That can only be done by a professional tax advisor who has analyzed your situation in regard to past, current and future tax years.  S/he may decide that it would be a good move to file an amended return (1040X) to report the net business loss so that you can carry it forward.  If the 1040X results in a refund claim, your tax pro should weigh this against the increased risk that would create of triggering an audit of the entire return, as I have discussed in several blog posts.

At a minimum, s/he should analyze your expenditures in the unreported year, looking for fixed assets that should have been capitalized for depreciation purposes.  It might also be possible to capitalize some of the other expenses as start-up costs and amortize them over future years.  Neither of these kinds of analysis is something that you can do on your own; so don't even try.

Thank you for sharing some of the details of your real life case.  I hope that you have learned from your mistakes and by posting this on my blog, I am hoping that others will learn how to avoid making those same mistakes on their tax returns based on your showing everyone what not to do.

Good luck.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 9/17/2006 01:53:00 PM Send this post: