Friday, March 3, 2023

The Parcheesi Club Gets Audited! (1099 forms)

Fear of the IRS is one of their greatest weapons.

The Parcheesi club is a 503(c)(3) organization, because in addition to putting on Parcheesi tournaments, they do volunteer work at schools and provide educational programs and training in the fine art of Parcheesi.  Seems like a pretty basic deal, but all the LoL's (Little Old Ladies) got their panties twisted into a knot when they found out they were being audited by the IRS!

Surely they would all go to jail and have to join a gang for protection - and get tattoos!  The end of the world is nigh!

It is funny, because we used to live in the DC area and our friends all worked for the "Gub-ment" - if not for the "three letter agencies" then for something like DoJ or IRS. My IRS friends told me that their greatest weapons were (1) withholding and (2) the irrational fear of the IRS.  No one expects the Spanish Inquisition!

Withholding is important, because if Johnny Lunchbucket never paid into the system during the year, he would be shocked, come April 15th, to find out he owed thousands in taxes (mostly to fund his own Social Security and Medicare in retirement) and he just wouldn't have the money to pay it.  So he would have to pay penalties and late fees, or take out a loan.  Withholding (and the so-called "Payroll Tax") pre-pays these taxes and at the end of the year, it is all balanced out and most people get a small refund.

I digress, but for self-employed people, you are supposed to pay "Estimated Taxes" quarterly or even monthly.  And yes, they get all pissy if you don't pay throughout the year. Ask me how I know this. As an employer, you have to pay that withholding into the system every month as well, and "borrowing" from your employee's withholding is a very, very bad idea.  The IRS gets really, really pissy if you do that.  It is like borrowing from a loan shark - don't do that either!

The fear of the IRS is what keeps people in line.  Horror stories about being audited are passed around the cracker barrel and as a result, people are afraid of the IRS - unnaturally.   Ironically, the people most afraid of the IRS are middle-class wage earners whose taxes could be calculated on the back of an envelope.  They hear these fear stories and have this nagging fear in the back of their minds that they somehow filled out the forms wrong, and their spouse will have to visit them weekends in San Quentin or something.

This is not to say you should take taxes lightly, but to understand them.  And understanding taxes includes understanding how they are processed and what is kicked out by the computers as audit bait.

If you run a business or are self-employed, you have to file a tax return, and you list all your income as well as your expenses, on Schedule C.  You add up all your income and then subtract your expenses and come up with a net income number, which is what you pay taxes on.

If someone pays you a fee, say for Patent services, they generally issue you a form 1099 at the end of the year, saying how much they paid you over that year.  They also send a copy to the IRS.  In order for them to declare your bills as "business expenses" they have to file a 1099 for any amount over a certain number (say, $600 - it changes over the years, consult a tax advisor for current amounts).  Similarly, as a business owner yourself, you have to issue 1099 forms to contractors you pay, for example, your Patent searcher or Patent draftsman.

So you see, there is this interlocking web of 1099 forms.  And if a customer issues a 1099 to me and I fail to report that income on my Schedule C, well, the computer can detect this rather easily.  Similarly, if my client is deducting my fees as a business expense, they damn well better issue a 1099.  It creates a closed-loop system for the IRS, as deductions made by one business are offset by corresponding income declarations by another business.

One sure way to get audited is to not report income on your schedule C, particularly if a 1099 form has been issued to you.  Now even then, the consequences might not be so dramatic.  I recall one year, I forgot to put a 1099-INT form (interest income) on my Schedule B.  The amount was not that great, and they simply amended the return for me, sent me a notice to that effect, and reduced my refund by a small amount. IRS Agents are not the enemy - they are just people like you and me, trying to do a difficult job.

The computer also kicks it out if you declare someone's fees as a deduction, but fail to issue them a 1099.  Now again, this applies to contractors you hire.  You buy a box of paper from Staples, you don't need a 1099 for that - merely to keep the receipt for seven years.  If you hire the neighbor boy to wash the windows of your office, you need not issue him a 1099 unless he is paid more than $600 (or whatever this year's cutoff limit is).

The Parcheesi club stepped in the dogshit by not issuing a 1099 for their cleaning contractor, who vacuums the floors and wipes down the Parcheesi tables.  They paid them well over $600 for the year and claimed it as a deduction, but for some reason felt they didn't need to issue 1099 forms.

The computer kicks this out.  It is not a matter of a human even getting involved.  The scale is not balanced.  The income in Column A is not balanced by deduction in Column B.  No word on whether the cleaning contractor declared the income - they would be audited too, if they failed to declare income.  And by the way, on a scale of 1 to 10, failing to declare income is an 11.

Yes, you can go to jail for tax evasion, but it has to be pretty substantial and intentional.  Failing to report income or getting involved in sketchy tax-avoidance schemes can bring about criminal charges.  Taking home a box of paper clips from your company probably isn't quite at that level of malfeasance.  Declaring personal items such as girdles as business expenses, is - ask Leona Helmsley about that!

So, a newly minted IRS agent is on the case and going over the books and asking all sorts of silly questions.  The Club hires a lawyer and an accountant to handle these things, and it is doubtful there will by much in the way of taxes, fines, or late fees due.   The major hassle or expense is whether they have to file amended returns for the last seven years as well as retroactive 1099 forms.

A similar issue has been bugging me over Mark's pottery sales.  The Arts Association allows members to sell items in the "shop" attached to the gallery and the Association takes a 25% cut - which in the world of art is considered very generous.  They have never issued any 1099 forms to artists, even though many sell hundreds or even thousands of dollars of art per year.

This is where it gets weird.  You see, the IRS gets antsy about "hobby businesses" which I discussed before.  You decide to restore old cars and declare it a "business" even though you lose money every year and the cars you restore are just cars you collect and drive.  After five years of declaring losses and never showing any income you will get audited and the IRS will claim you are running a "hobby business" and trying to deduct what are actually personal expenses as business losses.

My Mother went through this with her bookstore - which rarely showed a profit.  She was incensed that the IRS Agent made noises about a "hobby business" which she took as a personal insult rather than a technical term for a tax concept.  Lesson learned: They showed a profit every few years and the IRS left them alone.  This is not to say you can take a real hobby and deduct it, only that for a real business, you can't just keep taking losses forever and not expect to be audited.

Since the Arts Association does't issue a 1099, we don't declare it as income.  Why? Because the expenses in making pottery are not offset by the income from the sales - by a long shot!  We spend close to $30,000 on the studio.  A new Kiln costs thousands.  The various tools, pottery wheels, slab roller, spray gun, compressor, spray booth, etc. costs thousands as well.  We could declare that small sales income, but it would be blown away by the cumulative expenses - and we would be showing a loss for every year for a decade or more.

But then the IRS would say "hobby business" and deny the loss!

But if the Arts Association did start issuing form 1099's then I would have to declare this on Schedule C and either pay tax on the gross amount, or itemize our deductions for clay, tools, materials, and of course, depreciate the cost of the building, the kiln, and the other tools of the trade. And again, we would show a loss, which would trigger an audit - Catch-22!

This is one reason why I have logged every expense Mr. See has made for his pottery hobby on Quickbooks, under the category "Pottery."  If the IRS comes a-calling, I can quickly show them a list of expenses that far outweighs the sales income.

So why do amateur potters sell their pots?  "It pays for the clay" they say (hey!).  Unless you are a full-time professional potter (they do exist), chances are, you aren't making money by selling your pots.  And the same is true for a lot of artists out there - and explains why art is often quite expensive, particularly for us middle-class people.   While "Collector" art might sell for millions at auction, lesser pieces might still command thousands - which most people still can't afford.   But in order for an artist to make any money at art, they have to charge pretty steep prices - that few can afford to pay.

Now you know why they call them "Starving Artists!"

The IRS audit at the Parcheesi club will eventually blow over and the nervous LoL's will calm down and change their panties.  It isn't quite the end of the world, Katy-Bell! as Booley would say.

But if you want to avoid an audit, issue a 1099 for contractors whose invoices you are deducting from your income!

UPDATE: A reader asks, "We hire a cleaning service for our house.  Do we need to file a form 1099 for them?

Answer, usually NO, unless you plan on deducting that as some sort of business expense (a pro rata portion perhaps, for your home office - but consult your tax advisor as it sounds like audit-bait to me!).  But things you buy and people you pay for personal use are usually not tax deductible and thus no 1099 is required.   Think of it as a balanced scale, with the 1099 form on one side, equaling a deduction on the other side.  You can't have one without the other.  Well, you can have a deduction without a 1099, but... damn!

On the other hand, do you really need a maid service?  It is a nice luxury, but you pay for luxuries with today's money that belongs to tomorrow you.