From the July 2007 issue of Wealth Manager Web • Subscribe!

July 1, 2007

The Tax of My Tears

When H&R Block ordered 25,000 packs of tissues this tax season, who could resist the image of teary-eyed taxpayers weeping over the money they owe? Indeed, many of us have felt like shedding a tear when our tax bill came due--and certainly when the IRS singled us or our clients out for an audit. But it's best to keep those emotions in check and approach the problem professionally.

The first emotion to get your clients over is that they are being picked on. The IRS freely admits that it singles out the wealthy for more attention, as the auditor's time is more likely to reap a reward. In 2004, the IRS audited 10,000 Americans earning more than $1 million; in 2006, it almost doubled the number to 18,000--more than 6 percent of all returns by this group.

Luckily, the higher their net worth, the more likely people are to remain calm, says attorney Robert E. McKenzie of Arnstein & Lehr LLP. McKenzie sets a quiet tone for his clients by taking a businesslike approach himself. "Executives like to evaluate risk and make a business decision," he says, so he gathers the facts, evaluates the case, sets realistic expectations of what might happen and helps the client choose among the available options based on the risk involved.

Still, "most people are just very intimidated by the tax man," says CPA Suzanne LoBiondo at Marcum & Kliegman LLP. "I always tell my clients, 'You're not going to go to jail. The worst case is you'll pay a little tax and a little interest.' "

Surely the best way to keep a meeting with the IRS unemotional is to stay home and leave things to the professionals. "Clients tend to get emotional, where a lawyer or CPA can be aggressive in defense of your position, yet still be professional," says attorney David J. Moise, principal in the tax controversy and procedure practice at Weiser LLP in New York. "We take the emotion out of it."

Andrea Kramer, who heads the financial products trading and derivatives group at law firm McDermott, Will & Emery, has seen 20 or 30 clients get so worked up that they lose sight of the end-goal, which should be holding down the tab. One client rejected an IRS compromise he felt was just not fair--and now, 14 years later, he's still appealing. The terms are worse than the original offer, and he's still paying legal fees and being distracted from his business and his family. "When the IRS offers a settlement, neither side is completely happy," Kramer says. "But often it's wise to accept it and move on with your life."

But when the other side of the table gets emotional, take advantage of it, Kramer advises. On one appeal, she pointed to the highly emotional state of the IRS agent and implied he was irrational in his pursuit of her client.

Sending a representative to handle your client's audit can do more than just keep things cool--it can protect them from legal liability. A taxpayer who fibs on a 1040 is guilty of one crime; lying to the IRS agent conducting an audit adds another. Indeed, if you have reason to believe that your client has not told the whole truth on his tax return, tell him to talk to a tax attorney rather than a CPA, so anything he says is covered by attorney-client confidentiality privileges. Conversations with a CPA are not privileged; an accountant can be forced to testify against a client.

Still, says Ronald Hegt, CPA and senior tax partner at Hayes & Co LLP, the vast majority of clients have nothing to hide--and nothing to fear from an audit but the cost of the fees involved. To keep those to a minimum, urge clients to take a two-pronged pre-emptive approach: Carefully gather all the documentation to support their claims, and attach everything that is required when filing the original tax return. While in general the rule is to never volunteer more than the IRS specifically asks for, consider a little extra if your client is treading on ground you know is likely to be questioned, such as declaring more deductions than income, exceptionally high medical deductions, offshore investments, conservation easements or charitable donations.

McKenzie's list of IRS red flags for 2007 includes charitable foundations that pay high salaries to family members or seem to be more focused on sheltering income than doing good works, corporate life insurance policies that are structured to shelter a lot of income, and inappropriate offshore tax havens--especially those that give clients debit cards so they can easily withdraw cash. "U.S. citizens are responsible for reporting all income earned worldwide from any source," he notes.

David Sands, CPA, senior tax partner of Buchbinder, Tunick & Co. LLP, also suggests taking care when you have large losses on a freelance business that looks like a hobby--such as photography or raising horses. "Take the deductions you are entitled to under the law," he says, "but hold onto every piece of backup."

Even better, says Greg Tait, CPA/PFS, of Berenfeld, Spritzer, Shechter, & Sheer, consider incorporating the business. "The IRS has an opinion that Schedule C filers tend to overstate their expenses. Incorporating your business removes the Schedule C."

Cheryl Rosen is a freelance journalist specializing in finance, corporate governance and technology. Her work has appeared in the Journal of Accountancy, CFO, InformationWeek, Optimize, Business Finance and Business Ethics. Her email is crosen2@optonline.net.

Reprints Discuss this story
This is where the comments go.