When it comes to the IRS and audits, there are times when a taxpayer may feel like they can’t win. This is often true.
If you have been reading this site for some time, you may recall our article involving Five Audits in Ten Years and the court concluding that this many audits in such a short period of time is not taxpayer harassment.
The audit rules and procedures strike a balance between allowing the IRS full access to information and authority to investigate and taxpayer due process and the right to some amount of privacy.
These rules and procedures create certain distinctions that are subtle. Distinctions that are not always clear. Distinctions that are only at issue if the taxpayer raises them.
The repetitive audit rules are an example of this. The IRS is prohibited from conducting repetitive audits. But what exactly counts as a repetitive audit? The IRS addresses this in CCA 20202501F.
Facts & Procedural History
The taxpayer owned and operated a wine vineyard. The wine vineyard included a main house, caretakers house, and guest house.
The IRS audited the taxpayer‘s tax return for year 1. It determined that the wine vineyard was operated as a hobby in year 1 and it disallowed the expenses for the wine vineyard.
The taxpayer filed a protest to ask the IRS Office of Appeals to review the case for year 1. Appeals concluded that the wine vineyard was not a hobby activity. It allowed 100% of the deductions claimed in year 1. The deductions resulted in a loss that was carried forward as a Net Operating Loss (“NOL”) to year 2.
The IRS exam function audited year 2. It proposed to disallow the wine vineyard expenses in year 2. It also proposed to disallow the NOL carryforward into year 2 from year 1.
The IRS exam function argued that the IRS’s proposed disallowance of the NOL carryfoward into year 2 was barred as a repetitive audit. The IRS auditor asked the IRS attorneys whether the IRS could adjust the year 2 NOL.
The Hobby Loss Rules
The IRS often audits tax losses. This is particularly true if the loss offsets income and results in a significant reduction of tax due.
The hobby loss rules generally say that deductions for activities that are not entered into for a profit are to be disallowed. Activities that are not entered into for a profit are those that the taxpayer undertakes for other reasons–such as “sport, hobby, or for recreation.” This is where the reference to “hobby” comes in.
Regulation § 1.183-2 provides nine factors that are to be considered in determining whether an activity is engaged in for profit. The Code also includes a presumption that an activity is for profit if the activity produced a profit in three of the last five years.
Taxpayers can also use the Form 5213, Election to Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit. This form asks the IRS auditor to put the audit on hold. In doing so, the taxpayer buys time to show that the three of five year profit presumption applies.
If the activity is a hobby, the deductions are lost. Short of losing these deductions, if the facts permit, the taxpayer may be able to amortize the costs as start-up costs or capitalize the costs.
These are topics for another article. This article is about the repetitive audit rules.
Repetitive Audit Rules
The repetitive audit rules are found in Section 7605. Section 7605(b) states:
No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer’s books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.
There has been very little guidance as to what counts as a repetitive audit. This guidance generally says that tax items taken in different years are not second audits. It also says that audits of multiple years at the same time, even if the audit is considering the same records for both years during the same audit, is not a second audit.
Same Deduction, Different Year
The rules do allow the IRS to audit NOLs in the year that they are used. Thus, the IRS is able to audit the NOL that originated from year 1 and is taken on year 2’s tax return. This is different than what we have in this case.
This case involved separate audits for different tax years. It involved the same type of expenses from year 1, that were embodied in an NOL that carried forward to year 2. The year 2 determination to disallow the NOL did not occur until after the IRS Office of Appeals had already allowed the deductions for year 1.
The IRS Attorneys concluded that the proposed disallowance of the net operating loss in year 2 was a repetitive audit. It noted that:
in the present matter, the Service is disallowing the NOL carryforward on the basis that the Vineyard is a hobby activity; the same issue that was audited and sent to the Office of IRS Appeals for consideration. This is the “second examination” or “repetitive audit” that I.R.C. § 7605(b) was designed to protect against.
The fact pattern in this article is somewhat unique. The IRS often does expand audits to subsequent years. That is common. Other than the largest taxpayers who are under continuous audit by the IRS, it is less common for the IRS to immediately audit the taxpayer for a subsequent year after it has closed a prior year. The IRS will usually just keep both years open and close them together.
It is also not common for the IRS Office of Appeals to work a case fast enough so that the year 1 appeal is already decided by the time the year 2 audit closes. In most cases, the year 1 appeal will not be decided by Appeals until year 3 or later. So the taxpayer does not yet have an appeals decision from year 1 that it can point to in support of the argument that there is a repetitive audit.
This timing issue is particularly problematic in that the prohibition on a repetitive audit has no enforcement mechanism. There is no penalty if the IRS presses ahead with the audit. Presumably, the taxpayer would not respond and the case would move forward to appeals or tax litigation. This may not be a great answer for many taxpayers, particularly smaller taxpayers who have NOLs.
But when there is a prior year determination for expenses that result in an NOL, the taxpayer should be quick to point out the repetitive audit rules. This can save a significant amount of time and effort defending a position twice. Of course, advanced tax planning can also help.