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IRS Audit Business Building Depreciation Issue, Please help

Forum|Forum|6 years ago
December 6, 2019
21 replies
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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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Best answer by TaxGuyBill

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.

https://www.irs.gov/pub/irs-drop/rp-15-14.pdf#page=57

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).

T

TaxGuyBillAnswer

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.

https://www.irs.gov/pub/irs-drop/rp-15-14.pdf#page=57

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).

abctax55

Level 15

@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.

HumanKind... Be Both

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

HumanKind... Be Both

rbynaker

Level 13

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

Is this related?

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

HumanKind... Be Both

M

Mishalk

Level 2

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?

abctax55

Level 15

@Mishalk

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

HumanKind... Be Both

M

Mishalk

Level 2

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

The_AntiTax_Man

Level 7

@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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