Tax Myth buster Series - If the IRS Doesn’t Question A Deduction, It Must be OK

Tax Myth Buster Series

If the IRS Does Not Question A Deduction, It Must be OK

By Wayne M. Lenell, CPA, PhD

Statement of Tax Myth:

I’m a salesman and I need to look nice to make my sales calls.  Therefore, I have been deducting the cost of business suits.  I’ve been doing this for years, and the IRS has never questioned it, so it must be OK.

The myth in the statement above is the implication that, just because the IRS does not question a tax deduction, it means that the IRS approves the tax deduction.  The taxpayer, in the above example, is assuming that when he files his tax return, someone at the IRS reviews the entire tax return and is satisfied that all claimed deductions are allowable.  That does not accurately describe the IRS process for accepting tax returns.

When a taxpayer files a tax return electronically, and 90% do, no human reviews the tax return.  The IRS captures all information electronically.  When a taxpayer files a paper tax return, there are more levels of processing, some of which require human input, but none of which check for the appropriateness of each business deduction.  The IRS employees check for completeness, such as whether the taxpayer has attached the required copies of Forms W-2, etc., and will conduct a math check of the tax return.

It is when the IRS audits a tax return that a tax deduction may come into question, but it depends on the type of audit as to whether a particular tax deduction will be challenged.  We use the term “audit” in common language to refer to any correspondence from the IRS regarding a tax return.  The IRS, however, has more specific definitions of correspondence.

The most common “audit” is termed a “correspondence examination.”  This occurs when the IRS computer system identifies an inconsistency in a tax return and the IRS computer generates an automated notice to the taxpayer.  Typically, a taxpayer will receive a correspondence examination when the taxpayer neglects to include an item on a tax return that is reported to the IRS by a third party such an a Form 1099-INT for interest on a savings account, or a Form W-2 that the taxpayer forgot to include from a job the taxpayer had for a short time in the previous year. These types of correspondence examinations are termed CP2000 notices.     

A correspondence examination could also include a request for the taxpayer to provide documentation for a specific item or items.  For example, if a taxpayer donates a very large amount to a charity, the IRS may ask the taxpayer to send the IRS a copy of the receipt for the donation.  If the IRS requests information for a particular item or items on a tax return, the taxpayer may erroneous conclude that all other deductions on the tax return are acceptable.  It is not that all other deductions are acceptable, rather, it is just that the other items did not rise to the level that the IRS would flag as unreasonable and worthy of questioning in a correspondence examination.

It is more likely that the IRS would question an item such a “business suits” in an “office audit” in which the IRS asks the taxpayer to visit the IRS local office and bring requested documentation to substantiate items on a tax return.  On the IRS forms, there is no line item for “business suits,” so the taxpayer may have lumped the cost of business suits in with another item such as “supplies.”  If the business being audited is large, and the cost of the business suits is relatively small, the deduction could pass the scrutiny of the IRS even in an office audit. Again, the taxpayer could erroneously conclude that deducting business suits is acceptable since the IRS representative did not question it during the office audit.

A “field audit” is similar to an office audit in that there is a face-to-face interaction between the IRS and the taxpayer.  The difference is that in a field audit, the IRS representatives visit the taxpayer’s office.  The IRS will generally conduct a field audit for large businesses when it would be impractical for the taxpayer to copy and send all the required documents to the IRS.  In a field audit, the IRS agent will have access to the taxpayer’s source documents including the general ledger.  The IRS agent will likely peruse the general ledger looking for certain items commonly found to be not deductible.  Through this process it is more likely to identify a non-deductible item such as business suits, but it is not certain that the IRS agent will discover it.  Therefore, it is possible that, even in a field audit, a non-deductible expense could slip pass the IRS. That doesn’t mean the item is truly tax deductible.

The least number of IRS audits, but also the most intrusive, are “National Research Program” audits.  These are line-by-line audits in which the taxpayer must produce documentation for each item claimed on a tax return.  In this type of audit, it is extremely unlikely that the IRS agent would miss something like taking a deduction for business suits and the taxpayer would learn that business suits are not deductible.

Though not the main point of this article, it is important to note that sometimes clothing may qualify as a tax deduction. In 1968, the flamboyant entertainer, Liberace, was audited for deducting thousands of dollars for the lavish outfits he wore on stage.  The audit went to court and Liberace, allegedly, wore one of his bejeweled, rhinestone-studded suits complete with feathered cape into the courtroom.  The judge took one look at him and agreed that such an outfit would not be appropriate as everyday attire.  This case set a long-standing precedent and litmus test for the tax deductibility of clothing, that is, if the clothing can be worn in normal day-to-day situations (such as business suits), the cost of the clothing is not deductible. If the clothing could not be reasonably worn “on the street,” such clothing is tax deductible.

In conclusion, just because the IRS does not question an item on a tax return, it does not mean that the IRS agrees with the tax deduction. A future, more-detailed examination by the IRS may reveal that the item is not deductible.