Pennsylvania Unreimbursed Expenses (UE) Tax Audits

I noticed that all of my Pennsylvania tax clients who took a deduction for unreimbursed expenses (UE) received an audit response letter from the PA Department of Revenue. The problem is that the cost of responding to the audit exceeds the economic value of the deduction. In that case, the most reasonable economic response is simply to pay the additional assessment rather than attempt to spend time and money to prove this small value deduction.

Conversely, this development also means that the Commonwealth of Pennsylvania is spending more of its resources on these UE audits that it could possibly recover in additional tax revenue for the state.

When I posed a question on this topic to tax professional peers, I was surprised with the response. These are some of their paraphrased comments:

1. The audit rate has risen sharply since 2013 and is now believed to be 100% among tax filers who take substantial deductions for UE. Prior years’ audit rate was high but less than 100%. Tax filers who were audited in 2013 are being audited again in 2014 if they take the deduction again. Tax filers who were not audited in 2013 are being audited for 2014.
2. The cost of responding to the audit is usually more than the cost of just paying the additional tax assessment. Few, if any, tax filers have the documentation required to sustain the deduction.
3. PA Department of Revenue knows that the ‘deck is stacked in its favor’, that the burden on the taxpayer in responding to the audit is substantial, and that its chances of prevailing on this audit are very high.
4. The PA Department of Revenue’s cost of prosecuting these audits exceeds the revenue collected.
5. Tax preparers who warned their clients of this risk were largely ignored.
6. Clients usually believe that since this deduction is allowed be law and they have always taken it in the past without challenge that they should continue to take the deduction
7.  PA law on receipt documentation is tougher than federal law. PA doe not allow per diem expense allowances.
8. Tax professional believe that PA Department of Revenue is acting unreasonably and is using the cost of audit response to assert an improper tax position.
9. This problem issue has been brought to the attention of Department of Revenue officials by many individual tax professionals and professional associations including loud complaints at last year’s “Eastern Working Together Conference” but no there has been satisfactory response yet.

This past tax season I warned clients that taking UE would increase the risk of audit. My tax service includes audit response included in the basic tax preparation fee, so this issue directly affects my work load and liability. My included response would be to amend the tax return without the deduction. If a client wished to to the accounting required to fully respond to the audit, the cost would be higher or, of course, they could handle the response on their own.

I conclude that this is a “lose/lose/lose’ issue from the perspective of the taxpayer, the state, and the tax preparer and the best approach is avoidance.

This coming year I will change my tax engagement letter to say that taking this UE deduction is a known audit trigger (not a risk but a trigger) and that this known audit trigger is not covered in the audit response included in the basic tax preparation fee.

I do not have adequate information to comment on this issue in other states outside Pennsylvania.