The overall objective of the audit was to determine what actions the IRS is taking to address noncompliant, high-income1 SB/SE Division taxpayers who claim business losses on a U.S. Individual Income Tax Return (Form 1040) Profit or Loss From Business (Schedule C) for activities considered to be not-for-profit. Specifically, we determined the methods the IRS uses to classify tax returns to be selected for examinations and the outreach actions employed to discourage taxpayers who claim these losses to reduce their tax liabilities. To accomplish the objective, we:
I. Contacted the IRS SB/SE Division Campus2 Compliance Services and Examination functions to determine if there were any action plans with target dates for implementation of methods to classify and examine returns with Schedule C hobby losses.
II. Determined what outreach methods the IRS has in place or planned to advise taxpayers of the rules regarding the use of Schedule C for activities considered to be a hobby.
A. Reviewed the public IRS web site (IRS.gov) and the SB/SE Division Intranet web site for information pertaining to the deduction of Schedule C expenses for not-for-profit activities. We also contacted the Stakeholder Liaison Headquarters to determine if there are any additional planned outreach initiatives for either individual taxpayers or tax preparers for this area.
B. Obtained the results of the 148 taxpayer cases for the limited testing for Tax Years 1998 through 2002 conducted by the IRS beginning in 2003 to determine if tax returns with hobby loss issues could be examined by correspondence examination.3 We analyzed 95 of the cases in which taxpayers agreed and paid the tax assessments, to determine if IRS contact with these taxpayers deterred them from filing Schedule C losses in the succeeding tax years.
C. Obtained a computer extract from the Individual Return Transaction File4 for Tax Years 2002 - 2005 Form 1040 Schedules C showing no profits, only losses, over the 4 consecutive Tax Years. The universe of taxpayers, many with significant income from other sources, meeting this criterion was 1,483,246.
1. Analyzed data to obtain statistics about the population, including the amount of taxes avoided in Tax Year 2005, by calculating the additional tax that would have been owed if the taxpayers had not taken the Schedule C losses.
2. Determined the number of taxpayers examined during this period using the IRS Audit Information Management System.5 The data were verified by matching a judgmental sample of 33 taxpayers' information to the IRS Integrated Data Retrieval System.6
III. To determine the Congressional intent of I.R.C. Section (§) 183,7 we contacted the Treasury Inspector General for Tax Administration Office of Chief Counsel and conducted additional research to obtain the legislative/regulatory history of I.R.C. § 183 and Treasury Regulation § 1.183-1.8
Appendix II
Major Contributors to This Report
Daniel R. Devlin, Assistant Inspector General for Audit (Small Business and Corporate Programs)
Philip Shropshire, Director
Lisa Stoy, Audit Manager
Carole Connolly, Lead Auditor
Timothy Greiner, Senior Auditor
Ted Lierl, Senior Auditor
Appendix III
Report Distribution List
Acting Commissioner C
Office of the Commissioner - Attn: Acting Chief of Staff C
Deputy Commissioner for Services and Enforcement SE
Assistant Deputy Commissioner for Services and Enforcement SE
Chief, Appeals AP
Chief Counsel CC
Deputy Commissioner, Small Business/Self-Employed Division SE:S
Director, Campus Compliance Services, Small Business/Self-Employed Division SE:S:CCS
Director, Communications, Liaison, and Disclosure, Small Business/Self-Employed Division SE:S:CLD
Director, Examination, Small Business/Self-Employed Division SE:S:E
National Taxpayer Advocate TA
Director, Office of Legislative Affairs CL:LA
Director, Office of Program Evaluation and Risk Analysis RAS:O
Office of Internal Control OS:CFO:CPIC:IC
Audit Liaisons:
Commissioner, Small Business/Self-Employed Division SE:S:CLD
Chief, Appeals AP
Chief Counsel CC
Appendix IV
Methodology for Determining the Number of Taxpayers and Potential Tax Avoided in Tax Year 2005
We used the following methodology to determine the number of taxpayers and potential tax avoided in Tax Year 2005.
First, we obtained from the IRS Individual Return Transaction File1 a computer extract of Tax Years 2002 - 2005 U.S. Individual Income Tax Returns (Form 1040) with an attached Profit or Loss From Business (Schedule C) showing no profits, only losses, over the 4 consecutive Tax Years. Our results identified 1,483,246 taxpayers that met this criterion.
We then calculated the additional taxes that would have been owed if taxpayers had not taken the Schedule C losses in Tax Year 2005. This was accomplished by using each taxpayer's filing status for Tax Year 2005 and applying the appropriate tax rate.
Next, we added back the amount of the Schedule C loss to each taxpayer's taxable income and computed the tax. We then subtracted the tax computed on the amount including the Schedule C loss from the tax computed by eliminating the Schedule C loss. This calculation provided the amount considered to be the tax avoided in Tax Year 2005 by claiming the Schedule C loss.
The total potential tax avoidance for Tax Year 2005 is $2,843,919,493 for 1,203,175 taxpayers. We determined 280,071 of the 1,483,246 taxpayers did not avoid any taxes by claiming a Schedule C loss in Tax Year 2005.
Appendix V
Management's Response to the Draft Report
DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224
COMMISSIONER SMALL BUSINESS/SELF-EMPLOYED DIVISION
August 20, 2007
MEMORANDUM FOR DEPUTY INSPECTOR GENERAL FOR AUDIT
FROM: Kathy K. Petronchak
Commissioner, Small Business/Self-Employed Division
SUBJECT: Draft Audit Report --Significant Tax Administration Challenges Exist in Determining Whether Individual Returns With Schedule C Losses Are Engaged in Tax Abuse" (Audit #200630039)
We have reviewed your draft report, "Significant Tax Administration Challenges Exist in Determining Whether Individual Returns With Schedule C Losses Are Engaged in Tax Abuse," and agree with the recommendations.
As you mention in your report, Internal Revenue Code (IRC) Section 183 presents challenges to tax administration. We appreciate your recognition of our efforts to address this difficult provision, especially within our Small Business/Self-Employed Division Tax Gap Communication Plan. An important component of this plan included sharing fact sheets and key messages with our practitioner and industry partners emphasizing proper application of the current tax law.
We plan to continue communicating with practitioners and industry groups to educate them about this and other tax issues where voluntary compliance can be improved. Per your recommendation, we will also share a copy of your final report with Treasury's Office of Tax Policy.
Attached is a detailed response outlining our corrective actions.
If you have any questions, please contact me or call Beth Tucker, Director, Communications, Liaison and Disclosure, Small Business/Self-Employed Division, at (972) 308-1676.
Attachment
Attachment
RECOMMENDATION 1:
The Commissioner, SB/SE Division should provide a copy of this report to the Department of the Treasury, Office of the Assistant Secretary for Tax Policy, to consider proposal of legislative changes to Internal Revenue Code (IRC) Section 183(d). The proposal should include establishing a clearly defined standard or bright-line rule1 for determining whether an activity is a business or not-for-profit activity.
CORRECTIVE ACTIONS:
We agree with your recommendation. Upon receipt of the final report, the Director Communications, Liaison and Disclosure will coordinate with Legislative Affairs to forward a copy to Treasury Tax Policy.
IMPLEMENTATION DATE:
October 15, 2007
RESPONSIBLE OFFICIAL:
Director, Communications, Liaison and Disclosure, Small Business/Self-Employed Division
CORRECTIVE ACTION(S) MONITORING PLAN:
Director, Communications, Liaison and Disclosure, Small Business/Self-Employed Division will notify the Director, Legislative Affairs once the report is shared with Treasury.
RECOMMENDATION 2:
Aside from a legislative remedy, due to the large number of tax returns with Schedule C losses being prepared by tax practitioners, the Director, Communications, Liaison, and Disclosure, SB/SE Division, should continue to coordinate with practitioner organizations to encourage compliance with existing provisions.
CORRECTIVE ACTIONS:
We agree that our education and outreach activities should include key messages regarding the current provisions of IRC Section 183 to further supplement the April 2007 Hobby Loss Fact Sheet. We will include key messages and talking points about IRC Section 183 tax obligations as a FY 2008 outreach initiative directed to practitioner organizations.
IMPLEMENTATION DATE:
July 15, 2008
RESPONSIBLE OFFICIAL:
Director, Communications, Liaison and Disclosure (CLD), Small Business/Self-Employed Division (SB/SE)
CORRECTIVE ACTION(S) MONITORING PLAN:
Director, Communications, Liaison and Disclosure (CLD), Small Business/Self-Employed Division (SB/SE) will advise the Commissioner, SB/SE Division of any delays in implementing this corrective action.
1 We categorized taxpayers with total income sources of $100,000 or greater to be high-income taxpayers.
2 The term potentially is used because an examination of books and records is necessary to determine whether there was tax avoidance or abuse.
3 Correspondence examinations are conducted through the mail, with the IRS typically asking taxpayers for more support regarding one or two simple issues on individual income tax returns.
7 The campuses are data processing arm of the IRS. They process paper and electronic submissions, correct errors, and forward data to the Computing Centers for analysis and posting to taxpayer accounts.
8 The tax gap is the difference between the amount of tax that taxpayers should pay for a given year and the amount that is paid voluntarily and timely. The tax gap represents, in dollar terms, the annual amount of noncompliance with the tax laws.
9 Correspondence examinations are conducted through the mail, with the IRS typically asking taxpayers for more support regarding one or two simple issues on individual income tax returns.
10 We and the IRS analyst who oversaw the test reviewed the returns for the remaining 45 taxpayers whose Schedule C losses had not been disallowed. Based on the IRS analyst's recollection of the cases, the Schedule C losses for 36 of the 45 taxpayers should also have been disallowed; however, the original case files were no longer available.
11 This includes * * * * * Five other taxpayers also appealed their assessments. The Office of Appeals conceded the assessment in four cases and * * * * * The three remaining taxpayers have not paid their assessments and have balance-due accounts.
12 Because of data limitations, we did not determine whether all consecutive losses were for the same activity.
13 The term potentially is used because an examination of books and records is necessary to determine whether there was tax avoidance or abuse.
15 We categorized taxpayers with total income sources of $100,000 or greater to be high-income taxpayers.
16 This System traces examination results through final determination of tax liability, including any actions taken by the IRS Office of Appeals and the Tax Court.
17 Our calculations were based on 1 year's tax, while a disallowed hobby loss could be for 3 or more years.
18Some Underlying Principles of Tax Policy, United States Congress Joint Economic Committee Study, Richard K. Vedder and Lowell E. Gallaway, Distinguished Professors of Economics, Ohio University, September 1998.
19 A bright-line test is a clear division between what is acceptable and what is not from a legal, accounting, or regulatory perspective.
1 We categorized taxpayers with total income sources of $100,000 or greater to be high-income taxpayers.
2 The campuses are data processing arm of the IRS. They process paper and electronic submissions, correct errors, and forward data to the Computing Centers for analysis and posting to taxpayer accounts.
3 Correspondence examinations are conducted through the mail, with the IRS typically asking taxpayers for more support regarding one or two simple issues on individual income tax returns.
4 The Individual Return Transaction File contains data transcribed from initial input of the original individual tax returns during return processing. Subsequent or amended return data are not contained in the File.
5 The system traces examination results through final determination of tax liability, including any actions taken by the IRS Office of Appeals and the Tax Court.
6 This is the IRS computer system capable of retrieving or updating stored information; it works in conjunction with a taxpayer's account records.
1 The Individual Return Transaction File contains data transcribed from initial input of the original individual tax returns during return processing. Subsequent or amended return data are not contained in the File.
1 A bright-line test is a clear division between what is acceptable and what is not from a legal, accounting, or regulatory perspective.
Deductions: Business expenses: Hobby losses: Activities not engaged in for profit: Itemized deductions. --The factors to be considered in determining whether an activity is a business or a hobby are listed in an IRS fact sheet. The rules governing the deduction of hobby expenses on Schedule A of Form 1040 are reviewed. Back reference:
The Internal Revenue Service reminds taxpayers to follow appropriate guidelines when determining whether an activity is a business or a hobby, an activity not engaged in for profit.
In order to educate taxpayers regarding their filing obligations, this fact sheet, the eleventh in a series, explains the rules for determining if an activity qualifies as a business and what limitations apply if the activity is not a business. Incorrect deduction of hobby expenses account for a portion of the overstated adjustments, deductions, exemptions and credits that add up to $30 billion per year in unpaid taxes, according to IRS estimates.
In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business. An ordinary expense is an expense that is common and accepted in the taxpayer's trade or business. A necessary expense is one that is appropriate for the business. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit.
In order to make this determination, taxpayers should consider the following factors:
Ÿ Does the time and effort put into the activity indicate an intention to make a profit?
Ÿ Does the taxpayer depend on income from the activity?
Ÿ If there are losses, are they due to circumstances beyond the taxpayer's control or did they occur in the start-up phase of the business?
Ÿ Has the taxpayer changed methods of operation to improve profitability?
Ÿ Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
Ÿ Has the taxpayer made a profit in similar activities in the past?
Ÿ Does the activity make a profit in some years?
Ÿ Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year --at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses.
If an activity is not for profit, losses from that activity may not be used to offset other income. An activity produces a loss when related expenses exceed income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.
Deductions for hobby activities are claimed as itemized deductions on Schedule A (Form 1040). These deductions must be taken in the following order and only to the extent stated in each of three categories:
Ÿ Deductions that a taxpayer may take for personal as well as business activities, such as home mortgage interest and taxes, may be taken in full.
Ÿ Deductions that don't result in an adjustment to basis, such as advertising, insurance premiums and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
Ÿ Business deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.
Link:
Ÿ Further information is available in IRS Publication 535, Business Expenses
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