PA unreimbursed business expense deduction creates an audit risk

For he past few years the Pennsylvania Department of Revenue aggressively audited the tax returns of individuals who took a deduction for unreimbursed employee expenses on Schedule PA-UE. The topic was covered by the Pittsburg Tribune in June 2014. My quick online poll of professional tax preparers last summer indicated that the audit rate was near 100% of 2014. In other words, it appeared that every taxpayer who took the deduction was audited last year.* Some public reaction in newspapers and social media cried ‘foul’, as described in this commentary, but most taxpayers simply found it cheaper to pay the difference back to PA after receiving the audit letter.

The core issues:

1. Almost all tax preparation software uses the unreimbursed expenses from the federal tax return to generate the state unreimbursed expenses. In fact, the legal criteria are actually different and PA requirements are more stringent than federal requirements.
2. For both federal and state deductions, detailed record-keeping and proof of all transactions is required for the deduction. Estimates are not allowed.
3. Upon audit, PA requires a letter from the employer stating that the expenses are necessary. That requirement is not mentioned  in the state’s taxpayer education publications about the issue. Other public documents say that allowable expenses must be verified “either through receipts or employer verification” (emphasis added). But in fact the audit response states a requirement of both receipts AND employer verification. Few employees are willing or able to obtain this letter and are often surprised react negatively to the state requirement.

The question that remains is whether individuals who were audited in 2014 should take the deduction again in 2015. My opinion is that when the taxpayer meets the requirements for the deduction and is willing to obtain an employer letter later if requested, then they should take the deduction IF they understand the audit risk and are prepared to assume the cost of responding to that audit. If not, then the amount of money at stake in terms of tax savings is simply not worth the cost of an audit response.

The cost of responding to an UE audit, even it you do it yourself, is likely to involve labor valued at several hundred dollars. In most cases this is more than the tax savings available by taking the deduction. This is why, in the event of audit, that I advise taxpayers to simply pay the amount requested in the audit letter.

The issue that remains for me and other professional tax preparers is determining whether a taxpayer understands and has the right mental attitude toward the risk of audit. Of the three taxpayer clients I had in 2014 who took the PA UE deduction in 2014, all three were audited. One plainly blamed me for the audit, stating “I’ve always taken it before you prepared my return and there was never a problem”. A tax professional who takes the deduction risks adverse reaction when the state audits a tax return and possible even a professional liability claim. Two of the three clients audited last year did not return to have me prepare their tax return for 2015. So this audit risk issue actually represents a real business risk for me in terms of the significant cost of client recruitment and retention. This year I need to be more selective in which clients are psychologically prepared to handle the state’s hostile response to their option to take the UE deduction.

Footnote:

* Since then, I have found two PA taxpayers who took the PA UE deduction in 2014 and were not audited. So the audit rate is apparently not 100%.