A client was audited by New York State for their 2015 Married Filing Jointly tax return in 2016. Without communicating with me, they fell for the "Standard Deduction Seduction." By agreeing to accept the standard deduction, they agreed to pay $260 to the state to end the audit quickly, and they thought, inexpensively. They are supposed to file an amended return with the IRS, to reflect the disallowed deductions. I calculated the additional tax owed to the IRS as $2,600, 10 times the additional tax to New York State!
If they do not file this amended return now, they may wait 4 years or more to get a demand for payment. It will have accumulated interest and penalty. The federal interest rate for individuals is currently 4%/year. A payment for the 2015 tax return was required to be paid with the return on April 18, 2016. Interest until April 18, 2020 will add approximately $450.
The Failure to Pay Penalty is one-half of one percent for each month, up to a maximum of 25% of the amount of tax that remains unpaid. The maximum of 25% of $2,600 would be an additional $650.
There is no time limit, no defense, no negotiation, no audit documentation to present. It's a done deal. The total can be $260 + $2,600 + $450 + $650 = $3,960.
Let's call it $4,000 and be done with it!
How Did This Happen?
The New York State with New York City effective tax rate was 9.8%. The New York State MFJ standard deduction is $15,850. The state tax return automatically adjusts out the deduction for state and city income taxes, because they are not deductible on the state return, although they are deductible on the Federal itemized deductions. When deductions are disallowed, the higher standard deduction serves to limit the damage, on the state level.
This couple's Federal marginal tax rate was 25%. The Federal MFJ standard deduction is lower than the state, at $12,600, and the Federal itemized deductions are greater, because they include the state and local income taxes paid. There is a larger gap between the deductions claimed and the standard deduction.
This makes the impact of an adjustment on the Federal return greater than simply the difference in tax rates of Federal and State rates.
The Moral of the Story:
I. Understand that the impact of a small adjustment can be large.
II. Be serious and consistent about maintaining your documentation.
(How? That's the subject of a separate article: How to Document Your Deductions)
III. Fight every audit with a clear and professional defense.
(How? Use the Audit Defense Package: www.AuditDefensePackage.com)
Copyright 2017 Tax Strategies, Inc. Robert Greene CPA CMA