Joe is a dentist who owns Joe’s Bargain Basement Dental Clinic, P.C. The PC is taxed as a Subchapter S corporation meaning all of the income and losses flow through to him. He takes a modest salary. He personally bought the equipment and furnishings which is owned by Joe’s Leasing Company, LLC and leased back to his P.C. After taking his 179 credit, he reports the income on his Schedule E as leasing income. The first few years the leasing business showed a loss but by year 8 it started showing a profit which he duly reported on Schedule E of his Form 1040.

After about two years of this, he gets a notice from the IRS that his personal return is being audited. In particular, he is to bring all documentation regarding his leasing expenses shown on Schedule E. He calls a noted Tax Attorney to assist him in the audit, J. Franklin Beaumont. Mr. Beaumont looks at the return, and sees a problem.