Frank-
Not lore, but advice from a long time (now long retired) IRS agent, confirmed by a second one co-incidentally some years later, as to what their policies were. Not a hard rule, but a definite policy. One of these guys was an agent in charge of doing "sniff tests" on various small businesses and validating their claims and figures Both said, this was their rule of thumb: Show a profit in 3 years out of 5, or have a damned good reason not to have a profit, and a second reason showing that this was an actual business, i.e. your means of earning a living not just something you did on sunny weekends.
The IRS, and many tax departments at lower levels, do many things by "policy", not by formal rule and regulation. For instance, James mentions using credit card points. The IRS "policy" is to simply ignore credit card points in ordinary use, because trying to account for them can be a lot of accounting with little to be shown in the end. Odds are if someone is cheating on points (and who doesn't) then there's something bigger that they can be caught on.
Sometimes people think they are clever with taxes. Agent #2 caught a corner fruit store because he knew that they (like many big city fruit stores) were a cash business, sold every 3-5 years to a new crop of immigrants. He'd done an audit on the same store when the previous owners had it, and something about the receipts from the new owners just irked him. So he looked up the last audit records (still on file) and found that receipts for major equipment, like the cooler rooms, were in fact just photocopies of the ones the last owners had submitted. Busted, big time.
Or the local deli owner who paid ten grand (then a big amount) for his new car, explaining the cash was because every 5th sandwich he sold at lunch went under the table. (The cash, not the food.) Agent #1 said that really wouldn't help if he was audited, because the IRS would literally send an agent in every day for a week to buy lunch "for the office" and they would literally count every slice of meat, every pickle, napkin, foil wrapper, slice of tomato, slice of bread, and calculate how much of each item the shop really was using. Then they'd look at their purchase expenses, and inevitably the ratio of napkins to pickles, or bread slices to meat slices, would be off, even allowing for spoilage and mice, because the guy was deducting all of the purchases--but not showing the income from them. And they'd busted many shops exactly that way before.
Rule? Regulation? Nope. Just policy and procedure. The "3 out of 5" policy would be an easy one to simply program into the top-secret algorithm that the IRS uses to kick out returns for examination and audit. If that's all it is--it still is an extra way to get red-flagged.
Like all the folks who had their paychecks or receivables sent to an offshore bank account, and used an offshore credit card to spend that money, saying "There's no paper trail in the US, the IRS will never find out" until the IRS forced a deal to access those offshore records. Oopsie.
They can be persistent folks. Sometimes stubborn and wrong-minded, but always persistent.
So, write-offs that sound like vacations on a Schedule C? Red flag, unless you're in a "vacation" business.
