In an internal memorandum dated February 27, 2017, the Director of the Small Business/Self-Employed Division of the IRS issued guidance on a new pilot program auditing a select number of individual tax returns reporting Schedule F expenses.
IRS has conducted very limited Schedule F audits in recent years. Concerned about potential compliance issues, the Director details in the memo that the Brookhaven Campus will be conducting detailed, targeted audits of 50 2015 returns that include Schedule F expenses. The audits are to be conducted between April 1, 2017, and April 1, 2018. The memo states that, pending the outcome of the pilot, the guidance may be incorporated into the Internal Revenue Manual. In other words, stepped-up audit activity may be coming.
Targeted for the pilot audit program are those returns with high W-2 income, but also Schedule F expenses. These returns are most likely to include start-up costs or a hobby loss where enjoyment—not business—is the main focus of the activity.
The guidance contains specific directives for examining Schedule F expenses, including determining:
- Whether deductions are truly ordinary and necessary business expenses deductible under IRC § 162
- Whether farmers are properly distinguishing between custom hire expenses and amounts paid for equipment rental and employee wages
- Whether gasoline, fuel, and oil expenses are proper business expenses
- Whether mortgage interest is properly attributable to mortgage interest on real property used in the taxpayer's farming business
- Whether repairs and maintenance expenses are for the maintenance of farm buildings, machinery, and equipment that do not add to the property’s value or appreciably prolong its life
- Whether expenses for supplies, including amounts paid for prepaid supplies, are properly documented and fall within proper pre-paid limits