Taxes are due this month, so here’s a war story about an actual musician who was audited by the IRS and how he saved himself, with a little help from his accountant (who just happens to be me!)
Allow me to set the stage first. To receive a letter from the IRS announcing your federal income tax return is being audited will strike fear in the hearts of most mortals. Under such circumstances, when a taxpayer has the benefit of being represented by a CPA, a sigh of relief is often heard. However, when the taxpayer happens to be a performing artist – especially a musician – the cards are often stacked in favor of the government, even if you have professional representation.
Why? Simply stated, most people who make their living in the performing arts are already overwhelmed with their art. Details such as retaining receipts for business expenditures and keeping a diary of how money is spent may not be in the forefront of the artist’s mind.
So when a musician is audited, the burden of finding out all of this information falls on people like us – paid preparers.
Musicians show up at the accountant’s office with a shopping bag full of unsorted receipts. They spread these receipts out on the desk to be sorted, organized and categorized. The accountant has a daunting task ahead. Income as an employee (W-2) must be separated from self-employment income (1099). Some expenses go on Schedule C; some go on Schedule A. Form 2106 is used to record employee business deductions.
Believe it or not, keeping track of this stuff can actually be done by the taxpayer with a little coaching and encouragement from the accountant. This is better done before an audit than after, and using a computer program helps reconstruct the records.
Now let’s go to our war story.
Introducing our hero
Our musician, who I will refer to as “T” (for “taxpayer”), was employed by two major orchestras located on opposite coasts of the U.S.
T’s adjusted gross income was about $70,000, which included a couple of W-2 side gigs generating about $5,000. T had no 1099 or freelance income.
The meat and potatoes of the IRS audit dealt with documenting employee business expenses claimed on Form 2106, totaling approximately $27,000. This included airfare, out-of-town auto rental, books and subscriptions, cell phone, car expenses, instrument repair, Internet, per-diem costs, music supplies, publicity, office, postage, shipping, union dues and work-related legal fees.
The IRS audit notice letter did not challenge deductions for real estate taxes and interest on a primary residence. (Proof of these deductions is provided to the IRS for all taxpayers on Form 1098.)
However, the IRS said no to all of T’s business deductions – pending acceptable proof and documentation.
If T simply gave in to the IRS, he would have had to come up with $7,300, which included penalties and interest. Who has this kind of “extra” money lying around?
T asked me what the final settlement might look like. I replied, “I don’t know for sure, but I have a feeling that things will work out O.K.”
This case is a cinch?
Whew, this audit is going to be a cinch, I thought. They couldn’t have picked a better return to audit. T was a stickler for accuracy and maintained a complete and detailed daily diary with actual receipts to back up every expense. Mileage logs showed opening and closing readings on the odometer for each trip, which resulted in actual mileage numbers, not just estimates.
I had my client fill out a power of attorney form. Confidently, I mailed off a package to the IRS agent handling the case containing what I thought was perfect documentation for every item. Everything tied in to the penny.
Two weeks later I got a phone call from the auditor, who had obviously gotten up on the wrong side of the bed. The auditor told me that she would not read anything until she got a copy of T’s employer reimbursement policy.
What is an employer reimbursement policy? Just what it sounds like. It should be a letter that your orchestra, bandleader or contractor can write for you that confirms whether things like meals, mileage and parking are reimbursed to you or whether you pay for them yourself (in which case you may be able to deduct them).
T had requested these forms from his four employers at my earlier suggestion. Three responses had miraculously materialized, but getting the last one was near to impossible. The job in question was with a small local orchestra. There were rumors the group might fold because of budget restraints. Complicating matters, there appeared to be no one in the office to talk to about getting the necessary letter.
Can you imagine the typical busy musician with dozens of W-2 forms trying to get reimbursement policy letters from each employer? What are the chances of success two years after the gig, which is what happened here? (By the way, the IRS likes to notify taxpayers of audits in just a short enough time so the three-year statute of limitations will not expire.)
Let’s get real here. T earned $350 from this job. How much could the expense reimbursement be? Is this amount material enough to hold up processing of the entire audit?
Contact was finally made with an orchestra board member; the letter was forwarded, and the audit progressed.
The forms are biased
Let me get technical here for a moment, for those among you who are well-versed in tax details. There was an irony in T’s situation. If T were 100 percent self-employed, and expenses had been claimed on Schedule C instead of Schedule A, the entire issue would have been moot. Why? Issuers of 1099 forms often only include the base pay and exclude expense reimbursements. This implies the IRS regulations are not being even-handedly enforced – to the detriment of those who are employed as W-2 employees. If Schedule C expenses were properly documented, there would be no IRS hassle about reimbursements, such as what was happening in T’s case.
The auditor examined hundreds of receipts for expenses. Everything was perfectly organized. There were adding machine tapes (stone-age technology) tied into the work paper totals; those figures were matched to the tax return schedules. It would have been difficult for most unbiased observers to find a loophole in T’s meticulous record keeping.
The way I look at it, settling with the IRS can be O.K. If a taxpayer has to give in on some minor point to get the audit over and done with, so be it. (Isn’t it possible just one of those restaurant checks was personal?) With such excellent documentation in T’s case, how about the IRS allowing 99 percent of the deductions, and disallowing 1 percent: “Here’s a check for $75, let’s go home – everyone is happy.”
Think of the added incentive: the taxpayer also saves money on accounting fees by not being overly hard-nosed on every issue.
(By the way, here’s some advice if you’re ever audited some day. Whatever you do, don’t antagonize the auditor. Let the IRS think that it knows more than you do. Be humble.)
This is all fine and good until you run into someone like T’s auditor. Now it’s time to take the gloves off.
Drive my car
The second annoying audit issue dealt with automobile expenses. The IRS maintains that a taxpayer must use only one of the following two methods to calculate vehicle expenses:
1. Claim actual out-of-pocket expenses for gas, oil, repairs, depreciation, etc., then multiply by the percentage used for business purposes. (Personal use is not tax deductible, nor is commuting.)
2. Or, take the amount of miles you drove for business and multiply by a standard rate that the government sets each year. (The rate for tax year 2010 was 50 cents per mile.) This is called the standard mileage method.
Parking and tolls are permitted in addition no matter which method is chosen.
The standard mileage method happens to be a lot simpler to calculate and works well when mileage logs are kept as was the case during T’s audit. While at home on the East Coast, T used the car between jobs and we elected the standard mileage method. However while concertizing on the West Coast for a number of months, T rented a car and claimed both that expense and the cost of gas to run the car. The auditor proposed to disallow those expenses because T had allegedly used two different methods of accounting for auto expenses.
I responded that IRS Publication 17 states that when “operating and maintaining ‘your car’ when traveling away from home on business, you can deduct actual expenses or the standard mileage rate.” The implication of this paragraph is, if you are not using “your car” (the one left at home) there is no specific requirement to use a particular method. Incidentally, by calculating the average cost per gallon of gas on the rental car, projecting the miles driven and multiplying by the standard mileage rate for the year, we would have ended up with a larger auto deduction. The auditor, grudgingly, gave in.
The auditor had problems with the deductions for cell phone and internet, but a letter from the West Coast orchestra explained that without a permanent residence with a land line phone, there was no way to keep in touch with the personnel department. Musicians are always on call until released from the job. Hence, these were expenses for the convenience of the employer – and once again we prevailed.
Finally, we had to deal with the touchy area of legal fees related to T’s employment.
T is not a U.S. citizen. He is from overseas – an “alien” with extraordinary ability. To get into the U.S., T had to be sponsored by an orchestra (in this case, his East Coast employer), and that type of visa would not permit any other employment. Since the one job did not provide enough earnings to survive financially, T’s immigration lawyer filed an Application to Adjust Status and a Special Application for Employment. This created an opening to work elsewhere in the U.S. and resulted in T’s obtaining an even higher paying job on the West Coast.
Questions have often been raised about the deductibility of obtaining a “green card” even when an individual is sponsored by an employer. There is no clear answer to this question. The IRS often tries to assert this type of legal expense as personal.
In T’s case, a letter from the immigration attorney linked the legal costs directly to his ability to obtain employment. The facts and circumstances were so overwhelmingly in T’s favor, we prevailed.
Four months after the audit started, and thousands of words and numbers later, IRS wrote these fateful and awesome words: “We are pleased to tell you we did not make any changes to the tax reported on your return.”
This should have been the result from the very beginning, but we had to engage in hand-to-hand combat to get there.
Michael Kates, CPA, runs Brass Tax accounting services for musicians and other artists. He plays French horn, lives in Westchester, and is a member of AFM Local 38-398. Michael Kates can be reached at BrassTax@optonline.net or (914) 669-9800. See his ad on page 23 of this issue.