I was fortunate enough to be interviewed by an NBC News radio show recently and I have to admit, I was a nervous wreck. To make things worse, one of the host’s opening questions to me was “Does crime pay?” At first I did not understand exactly what his question was and as such I didn’t know how to answer that. So I asked him to clarify it for me.
The radio show host went on to say “I talk to some of my friends and sometimes, they tell me some outrageous stuff that they do to avoid paying taxes. I have friends who make a lot of money but have not filed tax returns years. I have also heard other investors who tell me they write off every penny that they spend regardless of whether it’s allowed or not. So I want to know….does crime pay?”
Once I understood his question, I felt my face turning hot from my nerves as I internally pondered the “correct” answer to provide. You see, as a CPA and being on a broadcasted radio show, I can’t legally or ethically say that I recommend someone use tax avoidance techniques. But at the end of the day, the answer to interviewer’s question really depends on the risk tolerance level of each taxpayer.
For example, I have a lot of clients who want to do everything exactly by the book. They want to make sure they have every single receipt before they write-off an expense. They want to make sure that nothing they claim on a tax return would even remotely be connected to an “audit red flag” item. So as a tax advisor, I do my best to make sure that we keep this client’s audit exposure to a minimum even though I sometimes may disagree with an over-conservative position. For example, I still have clients who refuse to claim a home office deduction because of hints from an old tax preparer over 10 years ago that it could be an audit risk. So each year, I explain to the client that this is no longer an audit risk and that I suggest they take the deduction. I try to quantify the potential loss of tax savings as a result of this but in the end if the client is not comfortable taking that deduction, then it is my job to make sure that my client’s tax return reflects their wishes exactly as they wanted.
On the flip side, I also have a lot of clients who want to be more aggressive on their tax returns (some more so than others). My job in this example is to let them know of the exposure and potential outcome in case of an IRS audit. For example, I have a client who has a very high W-2 income working a full time job. Back a few years ago, he got into real estate and promptly acquired 13 rental properties in one year. After we maximized all of his write offs with business expenses and accelerated depreciation, the rentals ended up with a huge loss on the tax returns. But because of his high income, he would have needed to claim real estate professional status in order to use all those losses on an unlimited basis to offset his W-2 income. Now, with his time log, he was most likely going to be able to support that he spent more time on his 13 new rentals during the year then his time at his job, but nonetheless, his tax return would be one with very high IRS audit exposure simply due to the fact that he had a large W-2 income showing. So my role in this example was to quantify the tax savings that he would get by claiming the real estate professional status. But I also needed to inform him that this tax savings comes with an elevated audit risk and explained what the potential process could look like if he were to ultimately get audited. After understanding the risks and the potential time commitment that he may need to deal with audit issues, this client made his decision to still claim the real estate professional status because he was comfortable with that risk. So just as in the last example, we filed his tax returns exactly as he wished for it to be reported.
At the end of the day, it’s not a matter of whether I think crime pays or not. It’s about each person’s risk tolerance level and where they fall within that spectrum. Just like one investor may find a tear-down shack to be a great fix and flip opportunity, another investor may run for the hills. The same goes for tax returns. Since the taxpayer is the one who ultimately signs on the dotted line, we need to file a tax return based on that taxpayer’s wishes.
Don’t forget, proactive tax planning can go a long way. I always say that when you are doing your taxes in April, there may be few strategies that can be used to offset taxes. But planning proactively with your CPA throughout the year is a great way for you to identify safe and legitimate ways to reduce your taxes. So my advice is to be “strategic” rather than “aggressive”. And remember….don’t wait for your CPA to call you, be proactive and call your CPA if you ever have any questions or think you may need help.
Here is an insider secret: summer time is generally slow season for most accountants so if you want to pick up the phone to chat, now is a great time to do that with your tax advisor!
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