Small Business Taxes & ManagementTM--Copyright 2015, A/N Group, Inc.
The article below was taken from a recent tax case. Because the case involved a number of issues and the facts were numerous and complex, we've simplified and condensed the facts to address the important tax issues. The facts and issues are not uncommon in smaller businesses. While the taxpayers' actions appeared to be honest, they resulted in additional taxes and penalties. We'll use our usual fictitious Madison when referring to the business.
Madison Landscaping operated as a sole proprietorship providing upscale gardening and landscaping. Madison wasn't the usual gardening business. While it provided regular landscaping maintenance for some of its clients, about 85%-90% of its business consisted of large projects at high-end homes. Its aggregate fees for these projects ranged from about $20,000 to $200,000 and its clients typically paid by check, not in cash.
The taxpayer had a business bank account but because of low balances, the bank would sometimes wait seven or eight days before making deposit funds available. As a result the taxpayer sometimes cashed customer checks he received at a local market for a fee. He used the cash to purchase materials, pay workers, and to put money into his joint account with his wife.
The IRS reconstructed the taxpayer's income. While it's not completely clear why they did so, the fact that the taxpayer cashed some of his business checks at the local market and paid himself and some of his expenses in cash piqued the agent's interest. The fact that many landscapers probably receive cash on a regular basis was probably another factor.
If you're in a business that regularly receives cash, you should be particularly careful about depositing all your income in the bank and transacting business through that account. Here the agent argued that later deposits of cash from checks cashed at the market were really cash received in the business, generating phantom income. The taxpayer claimed, and the Court agreed that the agent was double counting the cash deposits into the bank. The Court noted that cash bank deposits often occurred soon after a check was cashed at the market. For example, the date on a $9,000 check cashed at the market was April 2 and a cash deposit to the bank of $4,000 was made on April 9.
In this case the taxpayer was able to show that most of his customers paid by check. Nonetheless, he was still questioned on some other receipts he claimed were nontaxable. In particular, a $3,000 check he received from an individual with the same last name. The taxpayer claimed it was a loan from his sister. The Court accepted that, but only after determining the party was his sister, she lived near the taxpayer, and it appeared the check was not for services because it did not fit the pattern of other checks. The Court decided not to look at the factors that would indicate whether a loan was intended (e.g., formal promise to repay, etc.) or a gift. You should document the source of all nontaxable deposits (e.g., gifts from relatives) and nonbusiness deposits (e.g., dividend checks). Often all that you need do is make a copy of the check before depositing.
Madison used at least three trucks in the business during the years at issue--all full-size pickups. One of the trucks was purchased with a promissory noted and the security agreement indicated the truck would be used for personal rather than business purposes.
The taxpayer attempted to substantiate his business use with mileage logs. The court noted the mileage logs were not created contemporaneously. It was clear from a date that the logs were printed much later. The logs were also inconsistent with the tax returns presented. There was a discrepancy between the number of vehicles claimed on the return and the logs. The taxpayer claimed only one vehicle was used for personal purposes. The mileage dates and numbers in the logs did not agree with the maintenance and purchase record provided to the IRS agent. The court did not accept the logs and further noted that even if it were to accept the logs the taxpayer did not provide beginning and end of the year odometer readings. Finally, the logs provided no business purpose for the trips.
The court did allow depreciation on the vehicles and the IRS had allowed some operating expenses previously.
While it wasn't mentioned further, the fact that the taxpayer claimed in the loan agreement the vehicle would be used for personal purposes could be detrimental. You should be careful not to take one position on a loan or other document and take another on your tax return. At best you'll have some explaining to do, but the IRS could (and has) claimed the position on the other document is the one to follow. It could get worse if the IRS is asserting fraud since lying on a legal document is an indication of fraud. You can't have it both ways. Work the numbers and pick the best approach. In a case like this it's probably best to forgo the lower interest rate to secure a tax deduction.
Car logs are critical. They're not required on certain vehicles that are not amenable to personal use. For example, a van with only seating for the driver and passenger and special shelving in the back. While it may seem obvious that the pickup trucks were used in the taxpayer's landscaping business, they didn't escape the requirement to maintain a log or diary.
You can only deduct mortgage interest on amounts borrowed to acquire (or improve) your primary and a second residence (up to a maximum debt of $1 million) plus interest on an additional amount of debt of $100,000 (i.e., a home equity loan). Interest on a home equity loan has "no strings attached". You can use it for any purpose. But once you break that limit, the interest is not deductible.
That is, unless you can show it's deductible under some other section of the law. If you have a business, interest used to finance the business is deductible. That's easy to show if you borrow $35,000 to finance that new truck. The loan document will show the purpose of the borrowing and put a lien on the truck. If your S corporation goes to the bank and gets a line of credit and you draw down $15,000 and immediately write a check for the same amount to purchase inventory, interest on that amount would be deductible.
The Court disallowed a portion of the taxpayer's mortgage interest because it exceeded the limits. He argued that some of the amounts borrowed were used for the business. Unfortunately, he couldn't show the purpose of the amounts borrowed. If you're borrowing on your home, you should trace any loan proceeds to a business use. Then the interest on that amount would be deductible as business interest. It's generally easy to show the purpose if you leave a trail. For example, you need an additional $17,000 to complete the purchase of a new tractor. Write a check for that amount from the home equity (or other) account to the vendor or your business. If you write the check to your business, you should use the funds as soon as possible to complete the purchase of the tractor.
As usual, the rules can get complex. If you're considering such a move, talk to your tax advisor.
Copyright 2015 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 09/23/15