Help! I’m Being Audited: Are My Professional Fees Deductible?
When a taxpayer receives an audit notice from a taxing authority he or she should seek immediate professional assistance. Dealing with an audit is a complex process and a trained professional can assist you in avoiding many common pitfalls.
While hiring a tax professional to assist in your audit defense can be costly, in many cases, the fees paid can be deducted on your tax return. The nature of the deduction can depend upon what tax item(s) are being audited. In general, professional fees that relate to producing or collecting taxable income or receiving tax advice are deductible.
Individual Tax Audits
Audits of individuals can range in scope from a cursory look at a particular item of income or deduction to an intensive review of all items included in a return. This latter type of audit relates primarily to employed individuals and covers income and deduction items such as wages, pensions, mortgage interest, charitable contributions and medical expense deductions. In general, professional expenses associated with defending this type of audit are deductible as a miscellaneous itemized deduction on Schedule A of a tax return. It is important to note that to benefit from this deduction the taxpayer must itemize his or her deductions and the amount of all such deductions must exceed 2% of the taxpayer's adjusted gross income (AGI). Also, this deduction is not allowed to the extent that the taxpayer is subject to the dreaded alternative minimum tax (AMT) regime.
Self-Employed Individual Tax Audits
A self-employed individual who files as a "sole proprietor" will include a Schedule C in his or her tax return. Schedule C income/loss can also arise from activities through a single member limited liability company (LLC). Schedule C audits are very common especially if there is a resultant loss. Professional fees incurred defending an audit of this activity are deductible in full as an ordinary and necessary business expense. This is, of course, a much more favorable tax treatment than an employed person's miscellaneous itemized deduction. A Schedule C deduction does not depend on whether the taxpayer itemizes, nor is it limited in any material way. Additionally, it results in a reduction of AGI which may favorably affect other items on the tax return. The Schedule C deduction is also allowable under the AMT taxing regime and will benefit taxpayers subject to this tax.
Taxpayers often organize their business activities through partnerships or S corporations, which are reported on a taxpayer's Schedule E. These active trade or business income and deduction items can likewise be audited. The treatment of costs for defending these items are nearly identical to that of the Schedule C "sole proprietor." The only difference is that the costs are instead deducted on Schedule E. Additionally, a deduction of this nature on either Schedule C or E will reduce the taxpayer's self-employment income and the associated self-employment tax.
Audits of Passive Activities
Many taxpayers who invest in business activities through partnerships and S corporations, but do not materially participate in the business, will be subject to the passive-activity loss rules. These rules are complex and beyond the scope of this article. However, it is important to note that professional expenses incurred for the audit defense of these activities will also be subject to the passive-activity loss rules. If a loss is limited by these rules, it is merely deferred until the activity terminates or sufficient passive income (from this or other passive activities) is generated to utilize the loss. Similar to the Schedule C business audit, the deduction for professional fees on Schedule E does not depend on whether the taxpayer itemizes. Also, it results in a reduction of AGI and is allowable under the AMT regime.
Audits Covering Several Types of Tax Items
Very often, a single audit will cover several of the above categories. In this case, an allocation of the audit defense costs should be performed and the expenses deducted on the appropriate forms. A proper allocation of the professional expenses is critical to maximizing the deductibility of those fees. For instance, if an audit defense includes items from a Schedule C activity, that time should be documented separately to make sure the fees can be deducted on Schedule C as opposed to a less advantageous tax treatment. Like many other areas of tax, maintaining accurate and complete records is vital.
When is the Expense Deductible?
Individuals are almost always "cash basis" taxpayers. Therefore, professional expenses incurred must be deducted in the year paid. For example, assume that a 2009 tax return was audited during 2011. Let also assume that the professional work to defend the audit took place in 2011, but the bill for the services was not paid by the taxpayer until 2012. The expense would be deductible by the taxpayer on his or her 2012 tax return on the appropriate Schedule, depending on the nature of the item being audited, as discussed previously.
It is advisable to retain a trained tax professional to assist you in an audit. Professional costs you incur associated with the defense of specific items of income or deduction should be properly documented to obtain the most beneficial deduction for those costs. Costs associated with business items will generate the most favorable tax benefit, while those associated with personal and investment income items the least. A deduction for costs associated with defending passive activities is available, but may be limited due to the complex passive activity rules. One should consult a tax professional to determine whether professional expenses incurred relating to a tax audit may be deductible. For more information on audits, please see I Received an IRS Collection Notice: What are My Options? and Help! The IRS is Auditing Me!