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Jeremy Wells

The Nine Factors That Determine Whether a Business Is Real or Just a Hobby

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Susan Crile spent 25 years as a professional artist. In all but two of those years, she reported losses on her tax returns. When the IRS came knocking with a deficiency notice that could cost her tens of thousands of dollars, they claimed her art wasn’t a real business—just an expensive hobby.

What happened next became one of the most instructive Tax Court cases for understanding how to defend business deductions against IRS challenges.

In episode 16 of Tax in Action, host Jeremy Wells, EA, CPA, breaks down Susan Crile v. Commissioner (Tax Court Memorandum 2014-202)—a case he considers essential reading for anyone working with self-employed clients. As Jeremy explains, “If you work with small business owners, I strongly recommend reading through this opinion.”

When Your Business Becomes the IRS’s Target

The hobby loss rule creates what Jeremy calls a “heads I win, tails you lose” situation for the IRS. Here’s why it’s so devastating for small business owners.

When the IRS decides your activity is a hobby rather than a business, the tax consequences are brutal. “The income from these kinds of hobby, sport or recreational activities is still included in taxable income,” Jeremy explains. “But the reverse is not true. Those losses are not deductible.”

Think about what this means. If you’re an artist who sells $10,000 worth of paintings but spends $25,000 on studio rent, supplies, and marketing, the IRS still taxes that $10,000 as income. But if they say you’re pursuing a hobby, you can’t deduct any of that $25,000 in expenses.

Since 2018, when the Tax Cuts and Jobs Act eliminated miscellaneous itemized deductions (made permanent by later legislation), hobby expenses have been completely nondeductible. You pay tax on every dollar coming in, but can’t offset any dollars going out. The only exception is cost of goods sold (COGS), as the cost of raw materials can still reduce gross income.

The burden of proving your activity is a legitimate business falls entirely on you. Courts won’t just take your word for it. As Jeremy notes, “I can say I’m hoping to make a profit someday, but the courts look at all of the objective factors that go into how I’m operating that activity.”

Who’s at Risk (And Who’s Not)

The hobby loss rule applies to nearly every small business structure: individuals filing Schedule C, partnerships, S corporations, estates, and trusts. But C corporations are completely exempt.

Jeremy points to Amazon as a perfect example. “Amazon was a C corporation pretty much from the start,” he explains. The company famously took seven to eight years before turning a profit. “There was a long time there where investors were nervous that Amazon was never going to be profitable.” Yet Amazon never faced hobby loss scrutiny because C corporations don’t have to worry about this rule.

Simply forming an LLC or electing S corporation status won’t protect you. “Just registering an entity such as an LLC or just making a tax election, such as electing to be an S corporation, doesn’t necessarily guarantee that that taxpayer is not going to have to worry about the hobby loss rule,” Jeremy emphasizes.

For partnerships and S corporations, the determination happens at the entity level, not the individual partner or shareholder level. That affects how losses flow through to individual tax returns.

Susan Crile’s David vs. Goliath Battle

Susan Crile was a tenured art professor at a university when she received IRS deficiency notices in 2010. The IRS was challenging tax years 2004, 2005, and 2007 through 2009—five years where her losses ranged from about $37,000 to $63,000 annually.

The IRS made two arguments. First, they claimed her art activity wasn’t engaged in for profit. Second, they argued that even if it was a business, it should be considered part of her work as an art professor, making the expenses unreimbursed employee expenses rather than business deductions.

Crile believed this was a test case. In an interview after the decision, she said she felt the IRS was exploring “the art industry as a whole to see how far it could go in terms of auditing artists.” Whether that’s true or not, her case established important precedents for creative professionals everywhere.

The Nine Factors That Saved Her Business

The Tax Court uses a nine-factor test from Treasury Regulation 1.183-2(b) to determine whether an activity has a profit motive. Jeremy notes that this framework actually came from earlier court cases. The courts created the test, and the Treasury later adopted it into regulations.

Here’s how each factor played out in Crile’s case:

1. The manner in which she carried on the activity

The court found Crile kept “relatively good records” of sales, galleries, and exhibitions. She worked with a bookkeeper for most years in question. But what really impressed the judge were her business decisions, like switching galleries when she realized her current venue no longer attracted buyers interested in her type of art. The judge concluded, “Petitioner’s marketing efforts demonstrate a profit objective.”

2. Her expertise and that of her advisors

The IRS tried arguing that while Crile could create art, she didn’t understand the business of selling it. The court thoroughly rejected this. The judge found she “understood the general factors that affect the pricing of art: a history of sales, gallery representation, solo exhibits, critical reviews, prestigious public accolades, and she worked diligently to achieve these credentials.” The court’s verdict? “She is, without doubt, an expert artist who understands the economics of her business.”

3. Time and effort expended

Crile spent about 30 hours per week on art during teaching periods and worked full-time creating art the rest of the year. But the court looked deeper, distinguishing between tasks necessary for any activity versus those “essential only because she was conducting a business.” Mundane business tasks like marketing, networking with collectors, and arranging shows would be unnecessary for a hobbyist.

4. Expectation that assets may appreciate

The court recognized that art is “a speculative venture where a single event, a solo show, a rave review or a museum acquisition can lead fairly suddenly to an exponential increase in the prices paid for an artist’s work.” Artists create inventory that might sit at low values for years before that breakthrough moment arrives.

5. Success in other activities

Crile had been an artist for over a decade before becoming a professor. Her academic success actually enhanced her standing with art professionals and expanded her clientele. This factor was relatively neutral in the case.

6. History of income or losses

This was Crile’s weakest point: she had only two profitable years in 25. Jeremy acknowledges “the IRS won this point.” However, the court noted that some losses might have resulted from improperly claiming personal expenses as business expenses. The 2008 financial crisis had also devastated the New York art market during several years under review. Most importantly, the court stated that “losses do not negate the petitioner’s actual and honest intent to profit from the sale of her art.”

7. Amount of occasional profits

With just two years of reported profits, this factor “weighed slightly in favor of the IRS.” But the court remained sympathetic, understanding that in the art world, one breakthrough can change everything.

8. Financial status

Crile had a salary from teaching, but she’d been an artist for over a decade before getting that job. She didn’t become an artist to shield other income from taxes. This factor was neutral.

9. Elements of personal pleasure

The court offered this memorable insight: “A level of suffering has never been made a prerequisite to deductibility.” Yes, Crile probably enjoyed creating art. But her extensive research, marketing efforts, and business operations took her activity “well beyond the realm of recreation.”

The Verdict That Protected Creative Professionals

When the court weighed all factors together, “both qualitatively and quantitatively,” the balance tipped in Crile’s favor. She had proven “an actual and honest objective of making a profit.”

The court found that her activity was indeed a business, allowing her to deduct ordinary and necessary business expenses, and any losses were deductible. As Jeremy summarizes, “Her professional conduct, demonstrated expertise, significant time commitment, and reasonable expectation of appreciation outweighed even decades of losses.”

Clearing Up the “Three-of-Five Year” Confusion

Many tax professionals misunderstand the three-of-five year rule. “I hear this misstated a lot as an activity can’t lose money for three or more years before it’s not deductible,” Jeremy says.

However, that’s not what the rule says. If an activity shows profit in any three of five consecutive years (or two of seven for horse-related activities), it creates a presumption of profit motive. This shifts the burden of proof from the taxpayer to the IRS, but it doesn’t guarantee anything.

“Even if the activity does meet that safe harbor presumption, the IRS can still determine that that activity is not engaged in for profit,” Jeremy warns. Conversely, “an activity can not have profits for more than three years and still be an activity engaged in for profit.”

Practical Lessons for Tax Professionals

Jeremy transforms Crile’s victory into actionable strategies for protecting clients:

  • Document everything. “Documentation and record keeping is key,” Jeremy emphasizes. “Part of the reason Crile was successful is because she had a really good documentation system of her income, expenses, and all the work she produced and her efforts to market that work.”
  • Understand your client’s industry. Jeremy notes how “understanding how the art industry works was key to this case.” Crile brought in expert witnesses to educate the court about art market dynamics. When you can explain why a business operates the way it does within its specific market context, losses become understandable business challenges rather than red flags.
  • Focus on profit motive, not profit. “Having a profit motive isn’t the same as regularly making a profit,” Jeremy clarifies. Don’t scramble to show profitability. Focus documentation efforts on proving business intent.
  • Get to know your clients. Jeremy urges practitioners to understand their clients’ business vision, market strategy, and operational challenges. This ensures “when they go through those periods of losses, you’ve got the ability to make a solid case for them that that activity is, in fact, still engaged in for profit.”

The Human Side of Tax Law

Jeremy finds Crile’s case particularly valuable because it shows “how technical rules and factors at play actually work out in a real life scenario.” Reading the court opinion alongside Crile’s post-case interview reveals “the human side of the story.”

The case made national headlines, with coverage suggesting it protected artists’ livelihoods by confirming their work could be businesslike. But as Jeremy notes, each case is different. “It’s entirely up to the taxpayer to conduct an activity in a professional and business-like manner to avoid the hobby loss rule.”

For tax professionals working with struggling entrepreneurs, such as artists, gig workers, or innovative startups, Crile’s case provides a masterclass in building defensible positions. The tax code, despite its complexity, can accommodate the messy reality of business development when practitioners know how to document and present their clients’ genuine business efforts.

Listen to Jeremy’s complete analysis of this landmark case in episode 16 of Tax in Action. If you work with small business owners, he strongly recommends reading the full Crile opinion to ensure your clients never face the devastating financial consequences of having their business reclassified as a hobby.

The Math Behind Tax-Free Employee Discounts That Most Businesses Get Wrong

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Picture an airline employee boarding a flight home after visiting family, slipping into an empty seat at the last minute without paying a dime. Is this a tax-free perk or unreported income? The answer hinges on one crucial detail that could mean thousands of dollars in tax liability, whether that seat was reserved or simply excess capacity.

In this first episode of a multi-part series on tax-free employee benefits, Tax in Action host Jeremy Wells, EA, CPA, breaks down the complex world of no-additional-cost services and qualified employee discounts under IRC Section 132. As Jeremy explains, “Employers are constantly trying to figure out ways to encourage either prospective employees to want to come work for them, or for current employees to want to stay.” These benefits have become essential recruiting tools, yet their tax-free status depends on following precise technical requirements.

The Starting Point: Everything Is Taxable Unless…

Jeremy begins with a reality check that sets the stage for everything that follows. “IRC 61(a)(1) includes in compensation for services, commissions, fringe benefits, and similar items in gross income,” he emphasizes. “So in other words, if you get some sort of fringe benefit from your employer, it’s taxable unless there is some specific exception in the code.”

This means every perk, discount, or free service an employer provides is taxable compensation by default. Section 132 provides specific exceptions, but only if employers and employees follow the rules. Miss one requirement, and that tax-free benefit becomes taxable wages subject to withholding, penalties, and interest.

This episode focuses on two of the most common Section 132 benefits: no-additional-cost services and qualified employee discounts.

No-Additional-Cost Services: The Excess Capacity Exception

The concept seems simple enough: if providing a service to an employee doesn’t cost the employer anything extra, the employee can receive it tax-free. But as Jeremy explains, employers have to meet multiple requirements.

A no-additional-cost service must be “one provided to an employee for personal use,” Jeremy notes. “It’s ordinarily offered for sale to customers, and it incurs no substantial additional cost or foregone revenue when provided to the employee.”

The Reservation Problem

Jeremy returns repeatedly to airline examples because they perfectly illustrate the distinction between acceptable and problematic benefits. When discussing an empty airline seat, he explains, “The airline wasn’t going to sell that ticket anyway. So the airline isn’t losing anything. It’s not paying any more than it had to to add one more passenger to that flight.”

This is true excess capacity. Once the plane door closes, that empty seat has no value so letting an employee use it costs nothing.

But Jeremy warns about a critical limitation. “Employers can’t exclude reserved services.” If an employee reserves a seat while customers can still book the flight, “that airline potentially loses revenue if a customer wants to book that flight but can’t because the employee took the last seat.”

The employee could still take that reserved seat without paying, but “the airline would need to add the value of that ticket to the employee’s compensation as taxable income as part of the employee’s wages.”

Calculating Substantial Additional Cost

Determining whether a service incurs “substantial additional cost” requires careful analysis. “The employer has to include the cost of labor incurred in providing the service,” Jeremy explains. For modern service businesses, this can be challenging. While a manufacturer can easily track labor hours per widget, service businesses often struggle to allocate labor costs to specific services.

Jeremy offers some relief through the concept of “incidental services.” If a service is secondary to normal operations, it “generally doesn’t incur substantial additional cost.” This gives employers a near-safe harbor for ancillary services.

However, there’s a catch: “The employer incurs substantial additional cost if the employer or its employees spend a substantial amount of time providing the service to employees.” The vagueness is frustrating. “We don’t really get more detail than that,” Jeremy points out.

Reciprocal Agreements: Trading Services Tax-Free

One interesting provision allows unrelated companies to trade services. “An employer has to have an agreement with an unrelated other employer,” Jeremy explains, outlining three requirements:

  1. It must be a written reciprocal agreement
  2. The employee could exclude the value if their own employer provided it
  3. Neither employer can incur substantial additional cost

Jeremy emphasizes a crucial restriction. “If there are any payments involved between the two companies, then that is by definition a substantial additional cost and the entire agreement breaks down.” The exchange must be pure barter—services for services, no money changing hands.

Qualified Employee Discounts: Different Rules for Products and Services

While no-additional-cost services focus on excess capacity, employee discounts involve mathematical calculations that vary dramatically between services and products.

The 20% Rule for Services

For services, there is a clear bright-line test: “A discount on a service can’t exceed 20% of the price offered by the employer to customers.”

Using a simple example, “If your business provides a particular service to its customers for $100, then you can offer that same service to your employees for no less than $80” without tax consequences. Charge $70, and that extra $10 becomes taxable wages.

Gross Profit Calculations for Products

Product discounts follow a completely different formula. “The discount can’t exceed the gross profit percentage on the price offered by the employer to customers,” Jeremy explains. This requires complex calculations.

Jeremy walks through a practical example using a lawn equipment retailer offering employee discounts on push mowers. The store can’t just pick one model; it must aggregate. “Let’s look at the aggregate sales price. So of all of our push lawn mowers, what is the aggregate sales price of all of them?”

The calculation averages across the entire product line. “Some of them are going to be cheap. Some of them are going to be expensive. Some of them are going to be top of the line.” The employer calculates both average selling price and average cost to determine the gross profit percentage and that becomes the maximum tax-free discount.

The 35% Group Discount Rule

If a business regularly offers discounts to customer groups, such as seniors or military, and those sales comprise at least 35% of total sales, the discounted price becomes the baseline. “We’re trying to avoid inflating the price to act like we can afford a bigger discount for our employees,” Jeremy explains.

When multiple discount groups exist, employers can “choose the most common discount, the one producing the largest share of total discounted sales as the benchmark. Or if there’s a tie, it can average between them.”

What Can’t Be Discounted

Jeremy identifies surprising exclusions, including real estate, buildings, and land, and personal property usually held for investment, such as securities, commodities or currencies.”

Even businesses that primarily deal in these items, such as real estate brokerages and securities firms, cannot offer tax-free employee discounts on their main products.

Unlike no-additional-cost services, Jeremy makes clear that employee discounts have a major limitation. “You can’t create a reciprocal arrangement with another company to provide discounts on goods or services.”

The Compliance Framework: Who Qualifies and How to Document

Beyond the mathematical requirements are administrative challenges that can transform simple perks into compliance nightmares.

Nondiscrimination Requirements

Highly compensated employees—those earning over $160,000 in 2025 or owning 5% or more of the business—face special restrictions. They “can exclude no additional cost services, but only if the employer offers that service on substantially the same terms to each member of a group of employees.”

Jeremy provides a practical example of acceptable classification. “Once a new employee works for the business for at least six months or one year, then that employee is now eligible for the fringe benefit.” This creates an objective standard applying equally to all compensation levels.

Line-of-Business Limitations

This requirement emerged from the corporate consolidation era. “You started seeing businesses merging and acquiring other businesses,” Jeremy observes, “and pretty soon a business didn’t offer just one type of good, it might offer ten, 20, or 50 different kinds.”

The rule is, employees can only receive tax-free benefits for goods or services related to their line of business. Jeremy offers a clear example: “A bank can’t provide discounted apparel or groceries to its employees if it doesn’t also primarily sell clothing and groceries to its customers.”

However, employees supporting multiple divisions qualify more broadly. Administrative staff, IT professionals, and other infrastructure workers who benefit multiple lines of business can receive benefits from any division they support, even indirectly.

The Outdated Classification System

Determining lines of business relies on the Standard Industrial Classification system, which Jeremy notes was developed in 1938 and hasn’t been updated since 1974. Many modern businesses operate in industries that didn’t exist when these codes were created. While the Treasury proposed updating to the modern NAICS system in August 2024, employers must still navigate using pre-internet classifications.

Documentation Requirements

Jeremy concludes with essential documentation advice:

  • Document employees’ regular work to prove line-of-business compliance
  • Confirm services/products are offered to customers ordinarily
  • Quantify any costs or foregone revenue for no-additional-cost services
  • Calculate and document gross profit percentages
  • Maintain pricing records from when benefits were provided

“Document the terms of the benefit, ideally in writing,” Jeremy emphasizes, suggesting inclusion in employee manuals.

Looking Ahead: More Benefits to Come

Section 132 benefits reveal how simple concepts, such as free services and employee discounts, become complex compliance exercises requiring careful calculation and documentation. Yet for employers competing for talent, mastering these rules is essential for offering competitive compensation packages without triggering unexpected tax consequences.

Jeremy promises to continue this series in the next episode: “We’ll keep looking at Section 132 with working condition fringe benefits and de minimis fringe benefits.”

For tax professionals advising clients or business owners designing benefit packages, understanding these requirements is about maximizing value for employees while avoiding costly mistakes. The difference between a valued perk and a tax liability often lies in a single detail, such as whether a seat was reserved or whether discounts were properly calculated.

Listen to the full episode of Tax in Action to hear Jeremy break down each requirement with the clarity that makes complex rules immediately applicable in your practice.

When Good S Elections Go Bad and How to End Them Properly

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When businesses elect S corporation status, they often focus on the self-employment tax savings. But what happens when that election no longer makes sense—or worse, when it accidentally terminates? In episode 14 of Tax in Action, tax expert Jeremy Wells, EA, CPA, explores the complex process of ending S corporation elections, based on his firm’s recent experience with businesses struggling in the post-pandemic economy.

“A lot of small businesses that started up during the COVID-19 pandemic have seen business taper off quite a bit in the last year or two,” Wells explains. “Businesses that a few years ago actually made sense to be S corporations, nowadays not so much. And the owners want to stay in business, they want to keep operating, but it can be pretty burdensome to run an S corporation when profit margins aren’t what they were.”

Three Ways Your S Election Can End

Under IRC Section 1362, an S election remains in effect until termination, which can occur in three ways. Wells breaks down each path and the triggers that set them off.

1. Revocation by Choice

The most straightforward way to end an S election is to revoke it voluntarily. “An S corporation can revoke the S election for any taxable year,” Wells notes, “including the first year.”

The process requires shareholders owning at least half of the corporation’s shares (including non-voting shares) to consent in writing. Each consenting shareholder must provide their name, address, tax ID, number of shares owned, the date they acquired the stock, the date their tax year ends, and the corporation’s name and tax ID.

Timing matters. As Wells explains, “The corporation files that revocation statement by the 15th day of the third month of the taxable year. In general, if you’re working with a calendar year S corporation, that’s March 15th.” File after that date, and the revocation takes effect the following tax year.

This creates planning opportunities. “We’ll usually plan to go ahead and close out that calendar year as an S corporation,” Wells says when dealing with mid-year decisions. “But we’ll go ahead and get the paperwork ready and send in that revocation statement and make it effective as of the beginning of the following year.”

Corporations can also file prospective revocations for future dates and even rescind them if circumstances change. However, there’s a catch: if new shareholders join after the revocation is filed, they must also consent to any rescission.

2. Failing to Qualify

The second termination path occurs automatically when a corporation ceases to meet S corporation requirements. Wells emphasizes that “those qualifications have to be met continuously. It’s not just meeting those qualifications, electing S, and then not worrying about it anymore.”

Common disqualifying events include:

  • Exceeding 100 shareholders
  • Adding a nonresident alien shareholder
  • Having a shareholder that isn’t an individual (with limited exceptions for estates, trusts, and tax-exempt organizations)
  • Creating multiple classes of stock

The stock class issue causes particular confusion. “Voting versus non-voting stock does not create a second class,” Wells clarifies. “You can have voting and non-voting stock in an S corporation.” The problem arises when shares have different rights to distributions or liquidation proceeds.

“In an S corporation, every share of the corporation stock has to confer identical rights to distributions and liquidation proceeds to every other share of stock,” Wells explains. “So if I own 10% of the stock, I get 10% of the distribution. If somebody else owns 20% of the stock, they get 20% of the distributions.”

This is especially important for LLCs electing S status. “If you’re working with an LLC that’s considering electing S, it’s incredibly important to get a copy of the operating agreement, review it, and make sure there are no preferential rights, no waterfall distribution schedules,” Wells warns.

3. Excessive Passive Investment Income

The third termination trigger only affects S corporations with C corporation history. If a corporation has C corporation earnings and profits and generates passive investment income exceeding 25% of gross receipts for three consecutive years, the election terminates.

“Congress intended to make S Corporation provisions available only for businesses that are engaged in active operations of businesses, not those that are mainly involved in passive investment activities,” Wells explains.

The rules here get complex. Passive income includes dividends, interest, rents, royalties, and annuities not earned in the ordinary course of business. However, Wells notes important exceptions. For example, rent from a business actively managing properties doesn’t count as passive if the corporation “performs significant services or incurs substantial costs in the rental business.”

Since many modern S corporations started as LLCs and never operated as C corporations, this rule often doesn’t apply. Wells shares a close call from his practice: “The individual thought he needed to put his individual stock holdings into an LLC and then, for some reason, thought he needed to elect S for that LLC.” The only thing that saved this client was that the LLC had no C corporation earnings and profits.

The Hidden Withdrawal Option

Perhaps the most valuable tool Wells reveals is the withdrawal provision, found in Internal Revenue Manual 3.13.2.27.10.

“If the IRS accepts the withdrawal request, then the entity is treated as if the classification had never been elected,” Wells explains. This option is available only before filing the first S corporation tax return—March 15th for calendar-year corporations.

The withdrawal can be requested through correspondence or by filing Form 8832. Wells has used this for clients who received bad online advice. “We’ve done this before with small businesses that hadn’t even really gotten started yet. The taxpayer got some bad advice online and thought an S corporation starting off was the way to go.”

The advantage is that, unlike revocation, withdrawal doesn’t trigger the five-year waiting period before re-electing S status. “That corporation could elect S, withdraw its election, and then the next year decide to elect S again. And there’s no problem with that,” Wells notes.

When State and Federal Rules Diverge

State administrative dissolutions can come as a surprise to business owners. Many panic when they forget to renew their state LLC registration, but Wells offers reassurance based on multiple IRS Private Letter Rulings.

“The IRS still considers the S corporation in existence. So a state law administrative dissolution of an LLC does not translate into a termination of the S election,” he explains. “As long as the business continues operating and continues fulfilling its tax filing requirements, the IRS doesn’t appear to really care about what happens at the state level.”

There’s no need for a new S election when the entity gets reinstated at the state level. “Just keep operating as if everything is fine, at least at the federal level, and try to get that corporation or LLC reinstated at the state level,” Wells advises.

Critical Documentation and Next Steps

Wells emphasizes the importance of maintaining proper records. Keep the original Form 2553 and the IRS acceptance letter, as you’ll need to know which service center processed the election if you later want to revoke it.

Processing delays have become a challenge. “I’ve seen it take anywhere from six to 18 months for that S election to get processed,” Wells notes, partly because Form 2553 still requires wet-ink signatures and must be paper filed.

This episode is part one of a two-part series. Wells promises to cover the implications of termination, including the five-year rule and handling split years when termination occurs mid-year, in the next episode.

For tax professionals dealing with struggling businesses or succession planning complications, understanding these termination options preserves flexibility for clients whose circumstances change. As Wells demonstrates through his firm’s experience, what made perfect sense during the pandemic boom might need reconsideration today.

Ready to dive deeper into S corporation terminations and their implications? Listen to the full episode of Tax in Action for Wells’ complete analysis and practical guidance for navigating these complex scenarios.

The IRS Can Hit Your Clients With Criminal Charges for Bad Bookkeeping (And Most Tax Pros Don’t Know It)

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If you’ve ever received a shoebox full of receipts from a client or struggled with QuickBooks files where half the expenses are labeled “miscellaneous,” you know the frustration. But according to Jeremy Wells, EA, CPA, in this episode of Tax in Action, poor recordkeeping isn’t just a workflow problem. It’s a legal violation that could cost your clients thousands in penalties.

Most tax professionals treat recordkeeping like a suggestion. But it’s actually a federal requirement with serious consequences, including a 20% penalty on underpaid taxes and even potential criminal charges. Understanding these requirements can transform your practice and create new revenue opportunities.

Your clients are breaking the law (and they don’t know it)

Wells starts with a section of the tax code that most practitioners overlook. IRC Section 6001 doesn’t suggest or recommend. It requires taxpayers to “keep such records, render such statements, make such returns, and comply with such rules and regulations as the Secretary may from time to time provide.”

The Treasury regulations spell it out even more clearly. Taxpayers must keep “permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return.”

“The way I read this,” Wells explains, “you as a taxpayer, in order to file a tax return, need to have permanent books and records you can rely on in order to justify and substantiate any amount of gross income, deductions, credits, or anything else that you’re putting into that return.”

Here’s what catches many people off guard: tax returns themselves don’t prove anything. In Wienke v. Commissioner (T.C. Memo 2020-143), the Tax Court established that returns are “merely statements of claims and are not considered evidence of the claims themselves.” The real evidence must come from the taxpayer’s books and records. So when your client thinks their signed tax return proves their income to a lender, they’re wrong. Without proper records backing it up, that return is just a piece of paper with numbers on it.

The penalties for inadequate recordkeeping can devastate a small business. Section 6662 imposes a 20% accuracy-related penalty on any underpayment due to negligence, which specifically includes “any failure by the taxpayer to keep adequate books and records, or to substantiate items properly.” That’s 20% on top of the taxes owed, plus interest.

But it gets worse. Section 7203 makes willful failure to keep records a criminal offense. The penalties are up to $25,000 for individuals or $100,000 for corporations, plus up to a year in prison. While Wells notes that your typical shoebox client probably won’t face jail time, the existence of criminal penalties shows how seriously the IRS takes recordkeeping requirements.

The three warning signs every practitioner must recognize

These requirements create ethical obligations for practitioners too. Circular 230, Section 10.34(d) allows you to rely on client information, but requires “reasonable inquiries if the information as furnished appears to be incorrect, inconsistent with an important fact or another factual assumption, or incomplete.”

Wells calls these the “three I’s” that should trigger immediate concern. He shares a common example: “When I ask them what their business mileage is, they’ll just tell me a flat number that has three or four zeros at the end of it. As soon as I see that information, I already know, just in my gut looking at that information, whether it appears to be incorrect, inconsistent, or incomplete.”

When you spot these red flags, you can’t just ignore them. Wells describes the uncomfortable conversation that follows when he asks for a mileage log. “Nine times out of ten, they’re going to tell me they didn’t actually keep up with one.” At that point, you face a tough choice. Do you push harder for documentation, accept questionable information, or potentially end the client relationship?

“It might be a tough decision to stop working with a taxpayer because they want to claim a certain amount of miles,” Wells acknowledges. But when clients repeatedly ignore recordkeeping requirements despite annual reminders, “at that point, we might have to reconsider the relationship.”

How good records flip the script on IRS audits

While penalties provide the stick, there’s also a powerful carrot for maintaining proper records. Wells reveals how good recordkeeping can completely change the dynamics of an IRS dispute.

Normally, the IRS holds all the cards. The Supreme Court established in Welch v. Helvering (1933) that “the commissioner’s determinations have a presumption of correctness while the taxpayer bears the burden of proving the IRS position wrong.” Wells calls this “a tough hill to climb, especially for a taxpayer that has not kept good books and records.”

But IRC Section 7491 flips this burden. When taxpayers introduce credible evidence, comply with substantiation requirements, and maintain proper records, the burden shifts to the IRS to prove the taxpayer wrong.

“If a taxpayer shows up to an examination or an audit with good books and records,” Wells explains, “then the auditor knows that under Section 7491, now it’s on the IRS to prove the taxpayer is wrong.”

This creates “a more positive settlement climate,” according to a 2003 Tax Notes article Wells cites. Auditors become more willing to negotiate reasonable settlements rather than risk losing in court. He notes that even when a taxpayer takes a “technically incorrect position,” having good records to explain their reasoning can lead to much better outcomes.

Why the Cohan Rule won’t save your clients

Many practitioners rely on the Cohan Rule as a safety net, but Wells warns it’s been dangerously misunderstood. This 1930 court decision allows taxpayers to deduct “a reasonable estimate of the amount of a verifiable trade or business expense if the exact figure is unavailable.”

“I’ve heard, between bad tax advice on social media and some practitioners who haven’t really read the court case,” Wells says, people claiming “if the client doesn’t know how much, we’ll just fill in a number and appeal to the Cohan rule.” But that’s not how it works.

Courts take a harsh view of taxpayers trying to use Cohan without basis. In Barrios v. Commissioner (2023), the court stated it “bears heavily against the taxpayer who failed to more precisely substantiate the expense.” Translation: courts will slash your estimates, sometimes to zero.

Wells cites Williams v. US (1957), where the court refused to “guess” at expenses, calling relief without evidence “unguided largesse.” The message is clear: you need some reasonable basis for any estimate, not just a number that feels right.

Making matters worse, Section 274 completely blocks the Cohan Rule for certain expenses:

  • Travel
  • Entertainment
  • Business gifts
  • Listed property (especially vehicles)

For these categories, taxpayers must keep contemporaneous logs showing time, place, amount, and business purpose. Wells emphasizes how strict this is: “There have been tax court and federal court cases where the mileage log was simply thrown out and no deductions were allowed because the taxpayer attempted to recreate that log after the fact.”

Turn recordkeeping problems into profitable services

Instead of fighting poor recordkeeping every tax season, Wells outlines specific services that transform this challenge into recurring revenue.

His foundation is a “bookkeeping review service.” You’re not doing actual bookkeeping. Instead, you review the client’s records quarterly and flag issues. “We’re probably not going to look through a lot of five, ten, twenty dollar office expenses,” Wells explains. “But we might look through some expenses that are four or five, six figures.”

During these reviews, you might spot expenses that should be capitalized instead of deducted, deposits miscategorized as revenue when they’re actually loans, or aging receivables signaling cash flow problems. The key is efficiency. “They don’t take nearly as much time as actual bookkeeping does,” Wells points out.

He also strongly advocates for direct communication with clients’ bookkeepers, eliminating the game of telephone that wastes everyone’s time. Set up quarterly check-ins to discuss categorization questions, journal entries, and ownership changes before they become tax-time emergencies.

“This should not be free,” Wells stresses. “This should not be just included. You should not just start doing this out of the goodness of your heart.” Whether bundled into tax prep fees or structured as a monthly subscription, these services must generate revenue.

Some practitioners take this even further with preferred partner networks. Wells knows firm owners who refuse to prepare returns unless the books come from their vetted bookkeepers. While it sounds extreme, the benefits are clear. “They’re never going to have to worry about whether a deposit was really revenue or contribution of equity or new line of credit, because they trust the bookkeeper to have taken care of that already.”

For maximum scalability, Wells suggests creating educational resources. Use screen recording tools to solve common problems once, then share those videos with multiple clients. “Each time a client asks you a question, you know others have that same question,” he notes. This transforms repetitive education from a time drain into a reusable asset.

Listen to transform your practice

Recordkeeping isn’t optional; it’s legally required, with penalties ranging from 20% of underpaid taxes to potential criminal charges. But understanding this framework doesn’t just protect you and your clients from disasters. It opens doors to shift audit dynamics in your favor, negotiate better settlements, and create profitable advisory services.

Will you keep wrestling with shoeboxes every tax season, hoping estimates will pass muster? Or build systematic solutions that generate recurring revenue while protecting everyone involved?

Listen to the full episode to learn exactly how to implement these strategies in your practice. Because when you understand the legal framework—the requirements, the penalties, and most importantly, the opportunities—you stop just surviving busy season and start building a practice that thrives year-round.

When Insurance Payouts Trigger Unexpected Tax Bills (and How to Avoid Them)

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Jessica watched helplessly as Hurricane Idalia turned her North Florida print shop into rubble. After a decade of building her business, the commercial building she owned was beyond repair. Her insurance company cut a check for $250,000—good news after such devastation. But when she decided to lease a new space rather than buy, she discovered an unwelcome surprise in her tax return: a $50,000 gain she could have avoided.

Her story opens the latest “Tax in Action” episode, the third in host Jeremy Wells, EA, CPA’s series examining what happens when bad things happen. After covering casualty losses and theft losses in previous episodes, Wells now turns to the aftermath: what happens when you need to replace destroyed or stolen property.

While these moments represent some of the most stressful times in anyone’s life, IRC Section 1033 provides opportunities to defer or eliminate taxes on insurance payouts and other compensation. But as Jessica learned, you need to understand the rules to benefit from them.

More Than Just Natural Disasters

Most tax professionals think of hurricanes, fires, and floods when involuntary conversions come up. But as Wells explains, involuntary conversions can include government actions and even credible threats.

The fundamental test centers on control, not catastrophe. “A conversion of property is compulsory or involuntary if the taxpayer’s property, through some outside force or agency beyond her control, is no longer useful or available to her for her purposes,” Wells explains.

While casualties and thefts automatically qualify, including government requisitions, condemnations, and seizures opens up planning opportunities many practitioners miss. When a government agency takes property for public use, such as highway construction or urban redevelopment, the owner faces a true involuntary conversion. The compensation offered might not match market value, but the lack of choice triggers Section 1033 treatment.

The Willis v. Commissioner case from 1964 provides an important limitation. A transport company’s ship ran aground along the Atlantic coast. After getting repair bids, the company decided to sell the vessel and buy a replacement. They tried to claim involuntary conversion treatment. The Tax Court sided with the IRS, which argued that since the ship could have been repaired, the company’s choice to sell instead disqualified it. The property remained useful; it just needed repairs that the owner chose not to make.

This draws a clear line: property damaged beyond reasonable repair qualifies; property that’s merely expensive to fix doesn’t.

Even more surprisingly, just the threat of condemnation can qualify. Revenue Ruling 81-180 offers a perfect example. A taxpayer read a news account quoting a city official who said the city would condemn his property if it couldn’t negotiate a sale. The taxpayer sold to a third party rather than to the government. The IRS ruled this qualified as an involuntary conversion because he acted under a real threat of condemnation.

But the threat must be specific and credible. Revenue Ruling 74-8 clarifies that vague rumors won’t work. Taxpayers must point to a specific government agency and credibly claim they believe condemnation is imminent. This requires concrete evidence like official statements or confirmed news reports.

In an unexpected twist, Revenue Ruling 81-181 says that even if you knowingly buy property already under threat of condemnation, the later forced sale to the government still qualifies as involuntary. The IRS determined that Section 1033 doesn’t require you to acquire property free from condemnation threats.

Understanding these broader definitions transforms Section 1033 from a disaster-response tool into a planning strategy for navigating government actions and credible threats, which are situations far more common than natural disasters.

Choosing Between Nonrecognition and Deferral

The choice between nonrecognition and deferral can dramatically impact your client’s recovery. As Wells explains, the nature of the replacement property dictates which path is available.

Mandatory nonrecognition under Section 1033(a)(1) represents the gold standard. When property converts directly into replacement property that’s “similar or related in service or use,” the tax code mandates complete nonrecognition of any gain. No election required, no gain recognized. The basis simply carries over.

But determining what qualifies as “similar or related” has sparked decades of litigation. The IRS uses a functional use test, examining how taxpayers actually use both properties. If your warehouse is destroyed and you replace it with another warehouse, the use clearly aligns. But what if the replacement serves a different function?

The appellate courts created what Wells calls the “investor exception” in the 1960s, and it’s a crucial opportunity for rental property owners. In cases like Loco Realty v. Commissioner and Lent v. Commissioner, taxpayers owned commercial properties leased to tenants. After involuntary conversions, they bought replacement properties serving different functions. Warehouses became apartment buildings, and commercial spaces became retail shops.

The IRS and Tax Court said these weren’t similar uses. But the appellate courts disagreed. “From the taxpayer’s perspective, it’s still rental property,” Wells explains. Whether tenants operate warehouses or flower shops doesn’t matter when the taxpayer’s function—holding property for rental income—stays the same.

When taxpayers receive cash, which is the more common scenario with insurance payouts, mandatory nonrecognition disappears. Instead, Section 1033(a)(2) offers an election to defer gain, but only with specific requirements and strict timeframes.

Wells offers an example to show how this works. Seth owns rental property with a $100,000 basis. A storm destroys it, triggering $300,000 in insurance proceeds—a $200,000 realized gain. Seth uses $250,000 to buy a replacement rental property within the allowed period, keeping $50,000 cash.

Seth must recognize $50,000 in gain, as that’s the amount he didn’t reinvest. He can elect to defer the remaining $150,000, but his basis in the new property equals only $100,000, or the $250,000 purchase price reduced by the $150,000 deferred gain. When Seth eventually sells, that deferred gain resurfaces. “He hasn’t gotten out of recognizing the gain,” Wells clarifies. “He’s just deferred that gain into the sale of the replacement property.”

Principal residences add complexity through the interaction with Section 121. When a primary home faces involuntary conversion, taxpayers first apply Section 121’s exclusion: up to $250,000 single or $500,000 married filing jointly. Only gains exceeding these amounts are eligible for Section 1033 deferral.

The code also allows taxpayers to acquire controlling stock (at least 80%) in a corporation that owns similar-use property rather than buying property directly. While Wells admits uncertainty about when this would apply, the option exists.

A key limitation is that taxpayers generally must recognize gain if they acquire replacement property from related persons, such as family members or controlled entities. However, if the related party bought the property from an unrelated person during the taxpayer’s replacement period, or if the total gain is less than $100,000, the prohibition doesn’t apply.

Understanding the Critical Timing Rules

Even the best tax strategy fails without proper timing. As Wells explains, the replacement period creates a ticking clock that starts when disaster strikes. Missing these deadlines turns potential tax deferral into immediate gain recognition.

The standard replacement period begins on the date of the casualty or theft, or when the taxpayer first learns of a credible threat of condemnation. From that starting point, taxpayers have until the end of the current tax year, plus two additional years, to buy replacement property.

But Congress recognized that some situations need more time:

  • Three years for business real property taken by condemnation
  • Four years for principal residences destroyed in federally declared disasters
  • Five years for specific disasters (Midwestern floods of 2008, Hurricane Katrina, September 11 attacks)

The IRS may grant a one-year extension, but only for reasonable cause, like unfinished construction. “The taxpayer can make the request before the end of the replacement period and provide a reasonable cause explanation,” Wells notes. But market conditions, such as claims that property is too expensive or scarce, won’t qualify.

Jessica’s case shows the real cost of missing these opportunities. She received $250,000 and had two years from the end of the year to purchase replacement property. Instead, she immediately decided to lease. That decision cost her $50,000 in recognized gain. Had she bought a $250,000 commercial property within the period, she could have deferred the entire gain.

State tax rules add another layer. Wells highlights Oregon’s requirement that taxpayers who buy replacement property outside Oregon must add back the deferred gain when they sell. Oregon may even require annual reporting on out-of-state replacement property.

For tax professionals, mastering these timing requirements transforms crisis response into strategic planning. When clients call after receiving insurance checks, the first question should be about starting the replacement period clock.

Turning Crisis into Opportunity

Jessica’s $50,000 tax surprise could have been avoided entirely, and that fact underscores the power and complexity of involuntary conversion rules. 

The distinction between nonrecognition and deferral reshapes how tax professionals approach these situations. When replacement property is truly similar, mandatory nonrecognition eliminates any current tax impact. But when insurance companies write checks, the deferral election becomes critical. Keep even one dollar of proceeds, and you need to recognize a gain on that dollar.

For tax professionals, mastering these rules means providing exceptional value when clients need it most. The difference between Jessica’s $50,000 recognized gain and complete deferral is capital that could have accelerated her business recovery.

Wells concludes his three-part series with a powerful reminder: “When disaster strikes, the last thing anybody wants to worry about is the tax implications. But with a little knowledge, you can make sure that you or your clients get the best possible tax treatment.”

Listen to Jeremy Wells’ complete “Tax in Action” episode above for his classroom-tested approach to these complex provisions. The episode reveals how to apply the rules strategically when clients face their most challenging moments.