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Tax Strategy Problem for John Gemstone under IRS Audit

Can you help me start the following case study?

I:1-49
John Gemstone, a wealthy client, has recently been audited by the IRS. The agent has questioned the following deduction items on Mr. Gemstone's tax return for the year under review:

- A $10,000 loss deduction on the rental of his beach cottage.
- A $20,000 charitable contribution deduction for the donation of a painting to a local art museum. The agent has questioned whether the painting is overvalued.
- A $15,000 loss deduction from the operation of a cattle breeding ranch. The agent is concerned that the ranch is not a legitimate business (i.e., is a hobby).

Your supervisor has requested that you represent Mr. Gemstone in his discussions with the IRS.

a. What additional questions should you ask Mr. Gemstone in an attempt to substantiate the deductibility of the above items?
b. What tax research procedures might be applied to build the best possible case for your client?
c. Conduct tax research and formulate tax-planning advice for response.

Solution Preview

A $10,000 loss deduction on the rental of his beach cottage: in order to take a loss on the rental, it must be clearly established that there is no personal use of the cottage. You must ask the client about any such use, and if there was use, was the client doing repairs or other improvements that might justify his being at the cottage. Secondly, the client must construct or provide a chronology of rental history, payment receipts, lease or rental agreements, bank deposits or any of other documentation to prove the validity of the rental status of the property.

If the property is classified as a vacation home, there are certain deductions which are allowable but it is difficult to sustain a tax deductible loss with the vacation home. If it is a vacation home, you will require a record of days stayed for personal use, evidence of efforts to rent the property, and validation of expenses. That information will allow an agent to reconstruct the Schedule E following vacation home rules.

For the charitable donation of a painting, it is critical to establish value as of the date of donation. Presumably an appraisal was secured as required for any non-cash donation over $5,000. Present a copy of the appraisal to the agent together with information from the charity about a subsequent sale, for example. It is possible that another appraisal might be required, particularly if the art is still owned by the charity. If the artwork was sold at a value less than the appraisal claimed on the tax return, then evidence would be needed to demonstrate why there is a difference. It could have been a 'fire' sale or the painting could have depreciated in value due to market or other conditions. All of those facts will be needed to discuss the deduction with an agent. A letter from ...

Solution Summary

The 1186 word solution provides a comprehensive discussion of the issues and the possible approaches in dealing with the IRS. Included in the solution are the nine factors from the IRS regulations which may be used to determine whether an activity is, or is not, for profit.

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