IRS Audit of my Schedule C (Domain Business)!

[sitemaker]

I just got an IRS audit notice related to my Schedule C, which is my Internet Services business, which includes
buying and selling domains,
developing websites for paying clients (small neighborhood businesses),
remarketing hosting and domain registration services for those clients,
developing my own domains as forums and blogs for income via Adsense/Ebay/Amazon widgets,
and parking the rest.

I used "common sense" when accounting and filling out the returns, but would like to know (*before* I go into the audit) if I messed up anything.

For example, I'd like to know how most of us are evaluating "inventory". About 2,000 domains that are for sale get carried over from one tax-year year to the next. When dot-com bubbles burst (e.g., last decade), or when market rises, when/how do you mark to market? And what does IRS accept as evaluation method? What do the auditors like to see?

Is there a good overview of bookkeeping specific to domaining available online somewhere?

Should secondary market purchases be lumped in the same cost bucket as initial registrations (as they are both acquisitions)(e.g., cost of goods sold?)?

Should renewal fees be treated the same as initial reg fees?

Thanks.

---------- Post added at 09:27 AM ---------- Previous post was at 09:24 AM ----------

SHould renewal fee be current expense, or increase the cost basis of the domain?

 

[dn-101]

I think accounting rules are similar to the ones in real estate.
The best way to evaluate the portfolio is on the cost-basis. Forget about market fluctuations. Plus - this way you only make those ladies from IRS nervous.

SHould renewal fee be current expense, or increase the cost basis of the domain? - this is entirely up to you. but you have to stick with the same treatment year in & year out.
Expenses. You can't pay yourself salary, but you can pay somebody else to do the job. This is where bartering development work is great!

 

[Gerry]

I think accounting rules are similar to the ones in real estate.
The best way to evaluate the portfolio is on the cost-basis. Forget about market fluctuations. Plus - this way you only make those ladies from IRS nervous.

SHould renewal fee be current expense, or increase the cost basis of the domain? - this is entirely up to you. but you have to stick with the same treatment year in & year out.
Expenses. You can't pay yourself salary, but you can pay somebody else to do the job. This is where bartering development work is great!

Good points.

Most particularly, use the same method year in and year out.


The major issue here is non-domainers (IRS) knowing anything about domains.

As we have seen in some court cases and bankruptcy sales, domains are "assets".

Rather than treating this as "real estate" or "virtual real estate" (I really think everyone should move away from the real estate moniker), I personally would like to see (and do treat) each domain as one share of stock.

If you have 2000 names, then you own one share of stock in each entity (domain name) and the same rules of investing, capital gains, and capital loses should apply. Plus, there are "maintenance" fees which would be re-newal fees.


However, like I mentioned, good luck getting someone in the IRS to understand the concept of domain names as an investment.

 

[Biggie]

have only two entries


internet expenses

internet income


and lump all that apply into one or the other


imo...

 

[Focus]

biggedon is exactly right, we base our domain names value and sales on it's potential advertising income (or expense)

My business is an advertising business because I buy domains for advertising and advertise them for sale and incur costs as a result.

If you made 10,000 selling a domain and paid 5,000 for the name then you had a profit of 5,000 that is taxable income

Same exact thing goes for parking, you expense the domain name the same year it is not physical realestate it should not be broken up over a few years because it is not an asset you actually own. All domains are basically rented/leased from the registry you have to pay to keep them and renew them every single year and that is an expense as well that should be deducted every year for every name it's paid on.

I am not a tax lawyer and there are no real hard rules when it comes to domain taxes, basically we are establishing best practices now so just make sure you can show what you paid and what you made & keep it consistent each year and you should be fine. Good luck man!

 

[dn-101]

One other thing.
Uncle Sam (most probably, it would be a fat black lady with a mustache) doesn't need to know the names you owe.
Remember, we're democracy, and reporting is voluntary

 

[marcorandazza]

I just got an IRS audit notice related to my Schedule C, which is my Internet Services business, which includes
buying and selling domains,
developing websites for paying clients (small neighborhood businesses),
remarketing hosting and domain registration services for those clients,
developing my own domains as forums and blogs for income via Adsense/Ebay/Amazon widgets,
and parking the rest.

I used "common sense" when accounting and filling out the returns, but would like to know (*before* I go into the audit) if I messed up anything.

For example, I'd like to know how most of us are evaluating "inventory". About 2,000 domains that are for sale get carried over from one tax-year year to the next. When dot-com bubbles burst (e.g., last decade), or when market rises, when/how do you mark to market? And what does IRS accept as evaluation method? What do the auditors like to see?

Is there a good overview of bookkeeping specific to domaining available online somewhere?

Should secondary market purchases be lumped in the same cost bucket as initial registrations (as they are both acquisitions)(e.g., cost of goods sold?)?

Should renewal fees be treated the same as initial reg fees?

Thanks.

---------- Post added at 09:27 AM ---------- Previous post was at 09:24 AM ----------

SHould renewal fee be current expense, or increase the cost basis of the domain?

Call this guy

http://www.randazza.com/attorneys/Ricci.html

 

[Electric Star]

I am a semi-retired Enrolled Agent (an accountant enrolled to represent taxpayers before the IRS) and also dabble in building websites for people. The discussion of what to do with domain names has come up before -- here are some of the highlights. (And, as we say in the business, free information is worth what you pay for it, if you want a professional opinion to rely on I'll charge a professional fee, but this is the general info, and it's good as far as it goes.)

• If an end-user is registering or renewing a domain name, or many domains, this would generally just get written off as advertising or promotion expense, along with the fee to build or host the website.

• If an investor were to buy a single (think big here) domain in hopes that it will appreciate in value and then sell it, it would be a Schedule D transaction, or in other words, treated like the purchase and sale of a share of stock or a piece of land held strictly for investment..

• If a person is in the business of buying and selling domains, then the domain is placed in inventory, and the cost of the domain would be the inventory value. This cost is not deducted until the domain is sold, at which point the expense becomes part of Cost of Goods Sold shown ion Schedule C. Any renewal fees along the way would be added to the cost of the inventory, and thus expensed when it is sold. Yes, that could be a pain to track.
• Likewise, if you hand-registered the domain, that fee is your basis in the inventory, and you would proceed as above.

• Yes, there is a not-very-well-defined line between an investor and someone in business. There is not a set number of transactions between when you are an investor and when you are in business, but the auditor will look at the facts and circumstances of each case.

• The domains that you hold for your own use (your own sites, whether the business site or mini-sites) are deductible as current expenses. The direct income from those sites is current income.

The IRS will be reasonable about how you allocate the fees to the domains in your inventory. Any reasonable method of tracking this will do, as long as you are consistent about how you do it. (What they don't want is you working the figures differently each year to your advantage. Consistency is good.) In fact, it could even be argued that you could expense the registry and renewal fees as you incur them, as a cost of doing business, as long as you are consistent and not trying to work the system. But the textbook answer is increase te cost basis of the domain.

If you let the domain drop, you can then write off the accrued costs that were added to inventory for that domain at that time (i.e. treat it as if it were sold for zero dollars).

On the other hand, while it would be perfectly legitimate to mark-to-market the domains held for investment for accounting & financial statement purposes, there is no provision in the tax code for doing this. Besides, in the few cases where this is allowed, you would end up with income in the amount that the asset was marked up, so you really wouldn't want to do that anyway.

So, what did I miss there??

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[Gerry]

In fact, it could even be argued that you could expense the registry and renewal fees as you incur them, as a cost of doing business, as long as you are consistent and not trying to work the system.

In the above scenario, if one were to do this (claim it as an ongoing/recurring expense), then when it does sell those expenses are NOT included in the cost basis, correct? Simply submit the final sale value as income because the "cost basis" had already been claimed in an ongoing recurring year-to-year manner. Otherwise, this would be "double dipping" on the cost basis.

 

[Electric Star]

In fact, it could even be argued that you could expense the registry and renewal fees as you incur them, as a cost of doing business, as long as you are consistent and not trying to work the system.

In the above scenario, if one were to do this (claim it as an ongoing/recurring expense), then when it does sell those expenses are NOT included in the cost basis, correct? Simply submit the final sale value as income because the "cost basis" had already been claimed in an ongoing recurring year-to-year manner. Otherwise, this would be "double dipping" on the cost basis.

Yes, you are correct. You can, if it makes sense to do so, either add the fees to the cost basis or you can deduct them currently. But you would never be able to do both. Basically, you are only ever going to use that "expense" in one place.

 

[sitemaker]

Thanks for your advice, Electric Star. It's great.

What I'm learning from my accountant is that I need to create additional categories in Quicken, and create asset accounts for each registrar, and re-categorize all the transactions from original paper (or from invoice histories available online at GoDaddy, Fabulous, Enom, Reseller Club, OnlineNIC, DynaDot, DomainSite, Name.com, 1&1, et. al.) to get it all correct.

In the past, each payment to fund my Enom or other registrar accounts was expensed when the account was funded, biggedon's style. However, that's no good. Some of the payments made from the registrar accounts are truly cost-of-goods-sold, as my clients register or renew their domains at my website, which fulfills their orders automatically, deducting from my Enom or OnlineNIC account. Other transactions paid from those same accounts are my own registration/renewal activity.

Some of my own domains are operated for ad income, some held as investments. We're going to see if the auditor will let us expense everything. But if not, then inventory will be the acquisition or initial registration cost, and the renewals will be expensed as cost of continuing (or attempting) to operate the domain profitably. (Like a farmer capitalizes his tractor, but expenses the maintenance of it.)

It is also possible that the capitalized acquisition costs could be expensed over 5 years as intangible assets. However, in my case it's not worth the complexity to take advantage of this. (It might be worth it to you, if you were investing in only a small quantity of very high-valued domains.)

biggedon, if an IRS auditor questions your evaluation of your inventory on Schedule C, that auditor does indeed have the right to view your inventory list. In fact, in a forensic audit, they might even want to view all the invoices from each purchase, although a spot-check of a few random domains from your inventory sheet would ordinarily be fine, as long as the paper trail matches up with them.

After the audit, I'll post here again.

--- J.

P.S. -- The frustrating thing is that, after all this work to make the tax returns right, my tax liability is not going to change. It's just that by accounting for things the wrong way, such that the income and expenses weren't being put on the forms in the exactly right places (especially the inventory numbers), an audit was triggered.

 

[H2FC]

Thanks for your advice, Electric Star. It's great.

What I'm learning from my accountant is that I need to create additional categories in Quicken, and create asset accounts for each registrar, and re-categorize all the transactions from original paper (or from invoice histories available online at GoDaddy, Fabulous, Enom, Reseller Club, OnlineNIC, DynaDot, DomainSite, Name.com, 1&1, et. al.) to get it all correct.

In the past, each payment to fund my Enom or other registrar accounts was expensed when the account was funded, biggedon's style. However, that's no good. Some of the payments made from the registrar accounts are truly cost-of-goods-sold, as my clients register or renew their domains at my website, which fulfills their orders automatically, deducting from my Enom or OnlineNIC account. Other transactions paid from those same accounts are my own registration/renewal activity.

Some of my own domains are operated for ad income, some held as investments. We're going to see if the auditor will let us expense everything. But if not, then inventory will be the acquisition or initial registration cost, and the renewals will be expensed as cost of continuing (or attempting) to operate the domain profitably. (Like a farmer capitalizes his tractor, but expenses the maintenance of it.)

It is also possible that the capitalized acquisition costs could be expensed over 5 years as intangible assets. However, in my case it's not worth the complexity to take advantage of this. (It might be worth it to you, if you were investing in only a small quantity of very high-valued domains.)

biggedon, if an IRS auditor questions your evaluation of your inventory on Schedule C, that auditor does indeed have the right to view your inventory list. In fact, in a forensic audit, they might even want to view all the invoices from each purchase, although a spot-check of a few random domains from your inventory sheet would ordinarily be fine, as long as the paper trail matches up with them.

After the audit, I'll post here again.

--- J.

P.S. -- The frustrating thing is that, after all this work to make the tax returns right, my tax liability is not going to change. It's just that by accounting for things the wrong way, such that the income and expenses weren't being put on the forms in the exactly right places (especially the inventory numbers), an audit was triggered.

I would like to know how your audit came out.....is it over yet?

I took the 6 months extension and just now getting around to doing my 09 taxes. I report ppc income on schedule C and use part of my total renewal fees to offset most but not all of that income. I'm using schedule D to report sales and the balance of my cost and renewal fees mainly because I have some substantial carry over losses from prior years stock investments that I can use to offset some domain sales profits. I'm wandering now if splitting things up like this might give them reason for an audit.

Any helpful comments would be appreciated.

 

[Tia Wood]

http://www.domaintaxguide.com

 

[Theo]

Always consult with a competent CPA for matters related to tax.

Always consult with a competent attorney for matters related to legal issues.

Always consult with a competent doctor for health issues.

 

[stock_post]

Rule 101 for dummies

Always consult with a competent CPA for matters related to tax.

Always consult with a competent attorney for matters related to legal issues.

Always consult with a competent doctor for health issues.

 

[H2FC]

Always consult with a competent CPA for matters related to tax.

Always consult with a competent attorney for matters related to legal issues.

Always consult with a competent doctor for health issues.

Of course you're right but sometimes its helpful to get the opinions from other domainers who have had similar experiences especially with tax issues.

---------- Post added at 08:38 AM ---------- Previous post was at 08:34 AM ----------

Rule 101 for dummies

Rule 102 for dummies....always try to learn as much as you can about a subject before putting out money for a CPA tax advisor.

 

[domaingenius]

Would I be correct to suggest that a complicating factor of domain accounting COULD be the length of time that a domain is registered for ?. i.e. if it is only registered until end of the tax year in question then it could be considered differently to a domain that is registered for say 5 years or whatever ?. Also, how would trade mark domains be treated ,since they effectively have no value ?.

DG

 

[Theo]

DG - I can only speak about US taxation, as I see that you are in the UK: registration fees are qualified expenses in the respective tax year.

 

[sitemaker]

Status Update:

Every situation is a bit different, and equally important, every auditor is a bit different. In this case, after a meeting between my accountant and the auditor, the auditor seems ready to allow expensing everything in the name of avoiding business complexity because he can see that this is a sutation where there are literally thousands of domains owned, and the purchases and sales transactions are all for very tiny sums.

He simply, and quite reasonably, asks to verify that my expenses are real (even if not recorded in the proper lines of the schedule C originally). I need to provide copies of bank and/or credit card and/or paypal satements for the first month of each quarter (of the year being audited) -- whatever accounts will show that I really had the expensed claimed.

That's easy to do, and I think that's all there will be to it.

Will post here again when there's more to tell.

 

[katherine]

Thanks for the feedback.