The Moores were operating 3 businesses. A mortgage brokerage company, a real estate brokerage company and a used car dealership. Mr. Moore worked full-time for the City of Houston and supposedly ran the real estate and used car dealership. Mrs. Moore ran the mortgage business. According to the Moore's they often traveled 100 to 200 miles per day for their businesses. Mr. Moore's mileage log had the same abbreviations on virtually every day of the year with "generalized" descriptions of the business purposes of the trips.
The Moores filed their 2003 return well after the due date on 12/31/07. They claimed their 3 businesses lost over $84K which more than wiped out any taxes owed on Mr. Moore's wages of $51K. I'm sure you already guessed that the IRS thought this was odd.
The IRS issued a Notice of Deficiency in May of 2009 after redetermining the Moore's tax to be over $18K. On top of the tax, the IRS was looking for $3600 in late filing penalties and $3700 in accuracy-related penalties.
The Moore's made several mistakes with their Schedule Cs (the IRS form used to report self-employed business income and expenses) including:
- Deducting charitable contributions - while they are allowed on Schedule A as a personal itemized deduction, donations to charity do not belong on Schedule C as a business expense unless there is a business purpose to the donation. For example: donating to your local youth athletic association in exchange for advertising on their baseball fields.
- Trying to deduct start-up expenses of a new business before it opened - Mr. Moore claimed over $35K in expenses for his used car dealership before it was even open for business. The Schedule C for this business showed zero income, just expenses. None of those expenses could have been deducted until Mr. Moore opened his doors and even then they are recovered over a 15 year period through amortization (though there is an election to immediately deduct the first $5K in start-up costs in certain circumstances).
- Failure to keep adequate business records - the Moore's were unable (or unwilling) at the time they were audited to provide copies of invoices, statements, canceled checks, etc. to the IRS for their business expenses. When they went to Tax Court, they did have some documentation which the IRS did accept, but the IRS would not concede all of the deductions the Moore's reported.
- Failure to keep adequate mileage logs - the Tax Court noted that despite the taxpayers having logs, "those mileage logs, however, contained far too many errors, irregularities, and questionable entries to be considered reliable". The judge disallowed over $34K in auto mileage deductions.
What I want my self-employed clients to take away from this post is that I can't stress enough the importance of documentation of income and expenses.
- Get used to saying "can I get a receipt for that?" Your canceled checks and/or credit card statements are not enough if you are audited. You need proof of payment and proof of what you paid for.
- Fill out those mileage books I give you every year and be sure you are noting the business purpose of your travel! Want an app for that? I use MileBug for iPhone.
- Keep track of all of your income (checks, credit cards and cash received).
- Use separate bank accounts for your business and dedicate a credit card for just business expenses. It just makes things easier for everyone.
- Travel, meals and entertainment always have stricter documentation requirements than other business expenses.
- Ask questions of your Enrolled Agent if you are unsure if something is deductible. Hint: the expense needs to be both ordinary and necessary for your business. While a DJ would be allowed to deduct his iTunes downloads, that same expense wouldn't fly on my tax return.