Good Records Help if IRS Audits
Question: You frequently write about unusual tax deductions that ordinary taxpayers can legitimately take if they have good records. But because they are unusual, I’m afraid that taking them will make me that much likelier to be audited. Am I right to worry? And if I am audited and cannot pass the Internal Revenue Service’s scrutiny, what kind of fine would I have to pay?--T. K.
Answer: Yours is a legitimate concern. That is why it is so important to keep even better records than you think are really necessary.
Even in the perfectly normal area of charitable gifts of clothing and odds and ends, for example, even the most aggressive accountants recommend making an itemized list of every single stitch of clothing you contribute. Beside each entry you should list its approximate age, its condition, the price you paid (if possible) and your estimate of its value at the time you give it away. Each entry on your list should be stamped or initialed by the recipient--such as the Salvation Army, Goodwill or disabled veterans groups--to indicate that they received it.
How can you tell how much to discount such things as clothing? A good rule of thumb is to value them at 10% to 50% of original cost. Designer clothes that are still in perfect condition but that you have just tired of can probably be valued at half of their original price without raising IRS objections. Whittle that percentage down to as low as 10% if the garment is frayed or discolored or needs small repairs. Granted, there is guesswork involved here.
That gives you an idea of how extensive the IRS expects records to be. And if yours is a particularly unusual deduction or one that the IRS is trying to crack down on--such as home offices, low-interest loans to relatives and travel and entertainment expenses--the records need to be all that much better because you do run a higher risk of being audited.
But higher than what? Of the 96.5 million individual federal tax returns filed in 1984, only 1.31% were audited. Breaking down that figure according to income level, the Research Institute of America found that the audit risk grew with the income level. Of the 1040A returns filed by taxpayers with incomes of less than $10,000, only 0.35% were audited. The percentage rose to 0.44% for taxpayers with the same income level--less than $10,000--but who filed a 1040 return, presumably because theirs were more complicated.
For those returns by individuals with incomes between $10,000 and $25,000, the audit rate was 0.64% if the taxpayer didn’t itemize deductions and 1.67% if he did. For taxpayers reporting income between $25,000 and $50,000, the audit rate was 2.02%. And for those with incomes of $50,000 and higher, 3.53% of the returns were audited.
Obviously, it is the taxpayers with higher incomes who are most likely to take deductions that the IRS considers unusual.
Since the area of travel and entertainment is a particularly thorny one for taxpayers faced with an audit, here are some guidelines. Canceled checks are a good thing to have as backup, but they aren’t sufficient evidence for the IRS. You must keep a record of every expense you plan to deduct, along with receipts showing the time and place of the trip or entertainment and a detailed explanation of the business purpose of the expense and the business relationship of the person you entertained or gave a gift to.
What if you really did travel on business that your employer didn’t reimburse you for but you didn’t keep such records? Then the best you can do is to take a deduction based on the IRS’ standard allowance. You’ll be shocked at how low it is. Fourteen dollars per day. And if your travels last 30 days or more at a stretch, the allowance drops to $9 a day.
Now for your second question. If you are audited and the IRS doesn’t buy your argument for deductions, you will be assessed the additional tax that they say you owe plus 10% interest, compounded daily, on that amount. The interest will be calculated from the day your return was due until the day you pay the deficiency. As slow as the IRS sometimes is in auditing returns, that could be two or three years. That 10% interest rate, by the way, is the rate for the first six months of 1986. It is reviewed every six months and adjusted if the prime rate has changed significantly.
Those penalties assume you just goofed. If the IRS finds that you intentionally disregarded the tax laws, add a 5% negligence penalty. The agency also can tack on another penalty--equal to 50% of the interest due on the amount you underpaid if it feels the case warrants it. And if your extra tax bill stems from some property you grossly overvalued, expect yet another penalty. Overvaluing property by 150% to 200% can result in a 10% penalty. Between 200% and 250%, the fine doubles. And beyond that, the penalty is 30% of the amount you underpaid.
Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Business section, The Times, Times Mirror Square, Los Angeles 90053.
