This message from the IRS is every taxpayer's nightmare: "Your federal return for the period shown above has been selected for examination."
I worked from my studio apartment on the East Side of Manhattan. My returns had been prepared by a qualified tax professional who is also a registered investment advisor (RIA). I wasn't a Wall Street millionaire.
The IRS initially assured me I had been "randomly" selected as part of a program in which the agency pulls a certain number of returns for closer examination.
Totally unhinged, I felt like I was entering Dante's Inferno. In truth, the letter was the opening act of a five-month drama.
As the date for my audit drew closer, I methodically gathered all my receipts and documents to corroborate my business deductions as a self-employed writer.
Everything filled several boxes. I got little work done. People with whom I shared my predicament flooded me with stories, like the one about a woman I know who was summoned to the IRS offices five times.
In retrospect, it's now unbelievable that I felt so smug about my preparations. I waved away my advisor/tax preparer, when he offered to accompany me. Oh, no, I can handle it.
Sleeping very poorly for the two days before my initial meeting with IRS examiners earlier this year, I was exhausted when I arrived at the IRS office on W. 44th St. in Times Square. I passed through tight ground-floor security and ascended a long escalator leading up to another security desk. I towed my documents in a cart behind me.
I was greeted by an examiner-a tall, lean man with a shaved head-who I decided was the bad cop. He rarely smiled, but asked how I was. "Fine," I lied.
In a conference room, a second examiner, who was shorter and friendlier with shoulder-length hair-the good cop-took notes on a laptop.
Two examiners; was I this important? Or was I in so much trouble?
At the start, they noted my well-organized preparation. I relaxed. But the mood changed abruptly as they honed in on something I'd taken for granted: my home-office deduction. I learned later that the IRS becomes suspicious when a deduction is claimed for an office in a studio apartment.
Out came a thick book. The bad cop flipped through it near the middle and read straight out of the IRS Tax Code: "Taxpayers are not entitled to deduct any expenses for using their homes for business purposes unless the expenses are attributable to a portion of the home (or separate structure) used exclusively on a regular basis. ... This requirement is not met if the portion is used for both business and personal purposes."
Suddenly, I felt trapped.
They asked for a drawing of my work space. Complying a bit too quickly, I just drew my desk, chair, files and bookcases. Because I had moved recently and was worn out, I didn't include a table where I conducted my personal business.
The examiners were on to me. They cited the absence of a separate entrance or room devoted to my business. They also noted I didn't own a cell phone and therefore must have used my computer and desk phone for personal e-mails and calls.
I could feel hard-earned dollars melting away in the middle of a recession.
Periodically, the bad cop jumped up and left the room, then returned. If they were trying to intimidate me, it was working. It became clear they were going to tell me my little sliver of space in Manhattan didn't qualify as a valid home office.
They were nice to me when I was finally done (three hours later). I'd get a letter, they said, detailing what I owed in taxes-for two prior years.
"Don't forget your name tag," the bad cop said as I approached the security desk.
I was shocked, but felt like they had stacked the facts against me. My financial advisor/tax preparer, Kevin Tierney of KJT Investments, Manhattan, insisted I seek a second interview. He also insisted that I should let him accompany me. I didn't refuse. (And he said he wouldn't charge me, even though this isn't typical, since time is money for him, too.)
The examiners had misinformed me, he said, about having to have a separate room with a separate entrance.
We arranged a second meeting for a few weeks later. Only the bad cop was there this time.
Tierney made clear my work space was my sole place of business in a separate, fixed area that included a desk, chair, bookcases, file cabinets, computer, printer, fax and boxes. We claimed 47.3% of the apartment for my work area. My accountant emphasized my personal business was done at another table.
As was pointed out to me by Julian Block, a tax attorney in Larchmont, N.Y., "Home office deductions are at Ground Zero because the IRS knows that the rules are confusing and taxpayers routinely miscalculate the deduction."
The examiner asked for proof of my rent and an actual floor plan with square footage. We requested a third meeting, with a supervisor, which by law we were entitled to.
At the third session, an IRS supervisory revenue agent and the bad cop went back and forth with Tierney and myself over what to allow for business use of my home.
A compromise was reached, but I had won the big one, the home-office deduction, which would be crucial in the years to come because I planned to continue as a self-employed writer. We agreed that I could declare one-third of my apartment as business space.
Questions about my income were decided in my favor. Nonetheless, we agreed that expenses for telecommunications, meals and entertainment were not deducted correctly.
For those errors, I would have to pay the IRS a total of $1,376.50. They charged me interest, but no penalties.
The cloud had lifted. I could proceed with my life.
Bruce W. Fraser is a freelance financial writer based in New York. He is a frequent contributor to Financial Advisor magazine. He can be contacted at firstname.lastname@example.org. Visit him at www.bwfraser.com/home.
Tips Advisors Can Offer Clients to Avoid An IRS Audit
Be accurate in reporting items of taxable income from W-2s, 1099s, etc. The IRS matches information that they receive from their employers and banks with what is reported on their tax return.
The home office deduction has been targeted by the IRS as ripe for taxpayer abuse. If a client decides to take the deduction, make certain that he contacts a tax professional to determine how much should be taken and what he will need to do in order to sustain her deduction under audit. While he should take all deductions lawfully available to you, if their tax savings are not substantial thought should be given as to whether a deduction that the IRS considers "high-risk" should be taken at all.
The IRS matches the deduction of alimony support payments reported by a payor spouse to the required income pick-up by a payee spouse. If your client receives it, advise them to report it.
Clients should make certain all calculations on their tax returns are correct. A sloppy return may prompt the IRS to investigate further.
Remember to avoid claiming 100% of a deduction when it is limited in some fashion (examples: entertainment and medical expenses).
If a client is in an occupation that the IRS believes is at high risk for underreporting, his risk for audit is, thus, greater. As a result, he should be prepared to substantiate all deductions taken. Cash businesses, physicians' practices and law firms all fall into this category.
Preempt questions that the IRS may have regarding deductions that are unusually large by providing documentation with the originally filed return. Examples of deductions clients may want to document with their return are large charitable contributions and medical expenses.
No client should handle his own audit unless the amount involved is extremely small. One reason to have a representative is to maintain a sense of detachment. And clients should bring with them only those checks, receipts and whatever else is necessary to substantiate their position, and confine their answers to the questions raised. Otherwise, they may wind up with more auditing than they bargained for.
File returns on a timely basis.
Sources: Accountants Weiser LLP, New York City; Tax Attorney Julian Block