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IRS Audit Business Building Depreciation Issue, Please help

Ghost-Tax
Level 2

This person is going through an audit and he contacted me to ask if such a thing is possible:

In 2006 he purchased a building from which he used as his cabinet manufacturing place.  He did not take any depreciation during these years because he was barely breaking even and he did not want to do it.  He purchased the property for let's say 350k.  In 2016 he sold the building for 300k (a 50k loss) which was reported into the 4797 sales of business property.  This year he received an audit for 16, one of the things needing clarification being this issue.  The auditor calculated that instead of the 50k loss that he had on the tax return he actually has a capital gain of 134k.  When he asked the auditor how that is the auditor said that even though he did not take any depreciation it is consider as he did.  I've never heard of this thing in my life, anyone familiar? It can't be!

In the same audit the person paid a subcontractor with cash, about 40k (the sub signed each time the money was received) but the auditor said that since it was paid with cash it cannot be deducted.  That amount was included in a 1096/1099 form also but auditor requested all the checks paid to all subs.  Please help!

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TaxGuyBill
Level 14

As was pointed out, the depreciation a taxpayer is eligible to take lowers the Basis, regardless if they actually took it or not.  So the taxpayer has a gain from the sale.

However, Form 3115 can be used to 'catch up' on the missed depreciation.  Although the usual rule for Form 3115 is that is must be on an original, timely filed tax return, this specific change (change 107, in Section 6.17, for disposed property) is allowed on an amended return. So that will allow that full deduction (the deduction will be 'ordinary' rather than 'capital', which works out good for your client).

(3) Manner of making the change.

(a) Change made on an original return for the year of change. This change may be made on a taxpayer’s timely filed (including any extension) original federal tax return for the year of change (as defined in section 6.17(4) of this revenue procedure), provided the taxpayer files the original Form 3115 in accordance with section 6.03(1)(a) of Rev. Proc. 2015–13, 2015–5 I.R.B. 419.

(b) Change made on an amended return for the year of change. This change may also be made on an amended federal tax return for the year of change (as defined in section 6.17(4) of this revenue procedure), provided:

(i) the taxpayer files the original Form 3115 with the taxpayer’s amended federal tax return for the year of change (as defined in section 6.17(4) of this revenue procedure) prior to the expiration of the period of limitation for assessment under § 6501(a) for the taxable year in which the item of depreciable or amortizable property was disposed of by the taxpayer; and

(ii) the taxpayer’s amended federal tax return for the year of change (as defined in section 6.17(4) of this revenue procedure) includes the adjustments to taxable income and any collateral adjustments to taxable income or tax liability (for example, adjustments to the amount or character of the gain or loss of the disposed depreciable or amortizable property) resulting from the change in method of accounting for depreciation made by the taxpayer under this section 6.17.



As Anna pointed out, cash payments are allowed.  Although sometimes difficult to prove, it seems like the contractor is willing to help, so that should clear that up.  If the auditor still has a problem with that, you may need to request their supervisor.  Make sure the client knows that for any future businesses that payments should be by check and be connected to an invoice.

As for the other deductions that the auditor is claiming might be personal, can you show how those items would likely be used in the taxpayer's line of business?  If so, I would ask the auditor why he thinks they are personal, when that type of item is used for that type of business.  Personally, I am stubborn with that type of thing, and would insist on the auditor allowing those deductions (or appeal, or go to Tax Court).

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TaxGuyBill
Level 14

As was pointed out, the depreciation a taxpayer is eligible to take lowers the Basis, regardless if they actually took it or not.  So the taxpayer has a gain from the sale.

However, Form 3115 can be used to 'catch up' on the missed depreciation.  Although the usual rule for Form 3115 is that is must be on an original, timely filed tax return, this specific change (change 107, in Section 6.17, for disposed property) is allowed on an amended return. So that will allow that full deduction (the deduction will be 'ordinary' rather than 'capital', which works out good for your client).

(3) Manner of making the change.

(a) Change made on an original return for the year of change. This change may be made on a taxpayer’s timely filed (including any extension) original federal tax return for the year of change (as defined in section 6.17(4) of this revenue procedure), provided the taxpayer files the original Form 3115 in accordance with section 6.03(1)(a) of Rev. Proc. 2015–13, 2015–5 I.R.B. 419.

(b) Change made on an amended return for the year of change. This change may also be made on an amended federal tax return for the year of change (as defined in section 6.17(4) of this revenue procedure), provided:

(i) the taxpayer files the original Form 3115 with the taxpayer’s amended federal tax return for the year of change (as defined in section 6.17(4) of this revenue procedure) prior to the expiration of the period of limitation for assessment under § 6501(a) for the taxable year in which the item of depreciable or amortizable property was disposed of by the taxpayer; and

(ii) the taxpayer’s amended federal tax return for the year of change (as defined in section 6.17(4) of this revenue procedure) includes the adjustments to taxable income and any collateral adjustments to taxable income or tax liability (for example, adjustments to the amount or character of the gain or loss of the disposed depreciable or amortizable property) resulting from the change in method of accounting for depreciation made by the taxpayer under this section 6.17.



As Anna pointed out, cash payments are allowed.  Although sometimes difficult to prove, it seems like the contractor is willing to help, so that should clear that up.  If the auditor still has a problem with that, you may need to request their supervisor.  Make sure the client knows that for any future businesses that payments should be by check and be connected to an invoice.

As for the other deductions that the auditor is claiming might be personal, can you show how those items would likely be used in the taxpayer's line of business?  If so, I would ask the auditor why he thinks they are personal, when that type of item is used for that type of business.  Personally, I am stubborn with that type of thing, and would insist on the auditor allowing those deductions (or appeal, or go to Tax Court).

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abctax55
Level 15
:+1: :+1: :clap: :clap:
@TaxGuyBill  -  You deserve more that just ONE "up" vote for your answer.

@vlad  - you and/or your client owe TGB for his detailed/precise answer.

If necessary, ask for the auditor's supervisor regarding the "can't deduct any cash payments".  He is being unreasonable.
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rbynaker
Level 11
Awesome, thanks Bill!  Looks like good news about the 3115!

Having a cooperative contractor I think gives you a solid deduction.  Even if you have to go to appeals, no IRS attorney is ever going to take this to court when you can produce a third-party witness.
Ghost-Tax
Level 2
@TaxGuyBill wow, what an amazing answer!!!! Million thanks. We will definitely try that.
Since the audit is pending, do you think that we should present the auditor with the completed form or present him with a 2016 1040x?
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George4Tacks
Level 15
@TaxGuyBill I thought you were going to retire!  https://accountants-community.intuit.com/questions/1746141-minnesota-nonconformity
You had best not ever consider that again. We will come after you with pitchforks and flaming torches if you ever even think about retirement.

ex-AllStar
IRonMaN
Level 15
That retirement story was just a cover for some other issues.  I saw in the Star Tribune that his snowman kidnapping incident was going to trial next week.  "Retire" was just his cover for potential jail time. :snowman::snowman:
I'm keeping this job. But I am selling surplus anvils on the side. If you are interested please call 867-5309
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Marc-TaxMan
Level 8
Fake news:  It was a snow-woman and she recanted; they are on their honeymoon.
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abctax55
Level 15
Hope they didn't decide on a desert safari :wink::wink:
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TaxGuyBill
Level 14
@vlad   Personally, I would fill out the 1040X (that includes the 3115 and the §481 adjustment) and give it to the auditor and ask him if it should be filed separately outside of the audit, or if he just wants to incorporate it into the audit.

@George4Tacks   As much as I would love to retire, I have MANY years until I really can do such a thing.  Even if I were to retire, I would still 'hand out' here.   :smile:


I just added a new update on Holden (the snowman) in the Lounge.
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abctax55
Level 15

1) Search for allowed ir allowable regarding the depreciation.  Yes it's possible that there's a gain on sale instead of a loss.  The depreciation is considered whether taken or not.  That amount sounds a bit high...but I'm not at my desk.  WAS land factored in?  Eleven years x 2.56% x $ 350,000 =  ?

2) Research Form 3115

3) Cash payments are not, per se, disallowed. Proving them is a bit more difficult tho & it sounds like this auditor has a burr under his saddle. You'll need to look for court cases showing how to document cash payments

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rbynaker
Level 11
I'm with you, the math doesn't track on this.  Even if we assume the land value is minor we're looking at 25-30% of the 39-year life @ straight-line, let's call it $90K maybe?  So that's a $40K "gain" via recapture of allowable depreciation, I can't see how we get anywhere close to $134K.  I'd be curious to see what set of facts the auditor is using.

I'm no 3115 expert, but isn't it too late to change accounting methods for 2016?  I think this deduction may be lost.  I file this under "cost of NOT having your tax return prepared by a professional."

I can see "paid some guys in front of the Home Depot in cash" being disallowed but if there are signed receipts and a 1099 issued I wouldn't back down on that one.  Can you track the cash back to ATM withdraws?  Maybe get a signed affidavit from the contractor to appease the auditor?  And run through the employee vs. contractor checklist while you're at it.

Rick
abctax55
Level 15
$ 98560 (for a full eleven years on the full $ 350K).  I agree - even that amount wouldn't move the needle to $ 134000.
I still want to know about how the allocation to land was handled by either the DIYer, or the auditor

I have no idea if a "retroactive" F 3115 on an amended 2016 is possible (is it @TaxGuyBill that know these things by heart?).
It sure sounds like the existing trail of the cash payments is not bad (signed receipts & F 1099 done).  Either the auditor is being a real PITA or there's more to this story.
You're right - I have something posted at the office about (+/-) "if you thinks it's expensive to hire a tax pro, wait until you see the consequences of doing it yourself".  This appears to be a perfect example of that !
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abctax55
Level 15
Ah HA.
$48000 gain plus the wrong $50,000 loss plus the $40,000 disallowed =  $ 138,000.  That's close.
Except the depreciation wouldn't be THAT much, unless the land value is virtually zero.
NMI
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Ghost-Tax
Level 2
I think that the 3115 is only for a " a timely filed return" and not for an amended return.  I wonder if it can be taken on 18 for example even though the property was sold in 16, probably not.  From what this guy told me, the auditor is definitely a PITA and didn't allow him to deduct real business expenses because he told him they might've been "personal"
About the subcontractor issue, the guy said that the subcontractor is willing to write a statement that he received the money and he is even willing to show his tax return in which he claimed that amount also.
Any feedback, advises are highly appreciated, thank you
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abctax55
Level 15
"I wonder if it can be taken on 18 for example even though the property was sold in 16, probably not"
Seriously?
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abctax55
Level 15

Is this related?

https://accountants-community.intuit.com/questions/1560536-schedule-d-form-6252

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Mishalk
Level 1

Was your CPA well-prepared, with copies of all receipts and payments, as well as a detailed understanding of your company? Without seeing the case set out in gruesome detail, it's impossible to say what happened. Is the company successful for three of the five years to prove it was a business and not a hobby? It is your responsibility to prove the deductions; it is not the IRS's responsibility to justify why they should not be permitted.

The less structured the presentation, the less receipts, documents, and so on, the more likely the deductions would be disallowed. Expenses must, of course, follow fair and appropriate requirements, and employee business expenses are even more stringent due to the likelihood of reimbursement from your employer. 

They can't be just personal expenses, either (makeup, general clothes, haircuts).

What was the essence of the out-of-pocket costs? Certain products, such as those described properly, are prohibited unless extensive usage records and specialized documentation are provided.

How many audits had the CPA already completed? How many hours did it take to prepare? Has your representative specialized in audit protection and serving taxpayers at examination by courses and continuing education?

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abctax55
Level 15

@Mishalk 

Just FYI, this post is from 2019.  My guess is the audit is over with by now.

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Mishalk
Level 1
Sorry for inconvenience, new to this community but I'll be very careful about date for next time.
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abctax55
Level 15

No problem... and what you had to say was great.   Welcome to the zoo.

The threading on this forum is not ideal /S  (that S is for sarcasm...)

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The_AntiTax_Man
Level 5

@Ghost-Tax  the taxpayer claimed no depreciation expense on the building for the entire time that he owned it?  Did the auditor in his computations allocate the amount of the property's purchase price to land/lot and to the building? 

Did the taxpayer operate his business at the building immediately after he acquired it, or was there a period of time between purchase and conducting the business at the building?  How many years did the taxpayer operate a business at the building?  Did the taxpayer move the business out of the building in order to sell the building?  When did the taxpayer cease operations at the building?   What portion of the building was used for business operations?  Was the entire building used for his business, or was only a portion of the building used for the business? 

To compute the correct amount of depreciation "allowed or allowable" a timeline and the percent of business use are required to determine the correct amount of depreciation the auditor is using for his computations.

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