Anyone whose sits across my desk knows the drill. We chat about our families, you hand me your forms, I start keying data into the return and then I grill you for the things that don't show up on the forms.
"Did you purchase anything that would qualify for the Energy Credits? A new furnace, insulation, doors, windows, hot water heater...?"
"How much was your excise tax last year?"
"Did you take any college classes?"
"Any unusually high medical expenses you had to pay out-of-pocket?"
Let's pause for a second. Out-of-pocket. Merriam-Webster defines it as requiring an outlay of cash.
I thought it was self-explanatory; not tax jargon like amortization, double-declining balance, accelerated cost recovery, passive activity or unrecaptured section 1250 gain. Imagine my surprise when a client called me about an audit.
"Dave, the IRS is asking for all of my medical expenses from 2010. They want receipts, canceled checks, credit card statements...the works". I pull up the 2010 return and there was $13,000+ of medical deductions. I then pull up the document the client gave me listing all of their expenses. In my notes I wrote:
"TP (taxpayer) had surgery in 2010 and was put on many Rx drugs after. TP list shows OOP (out-of-pocket) expenses of $13,219."
I told the client to pull his records together and call back to schedule an appointment to write an appropriate cover letter to the auditor. The audit was being conducted by mail (as opposed to a desk audit where you actually show up at the IRS with your records) so I wanted to make sure the documents were easy for the auditor to follow.
The client shows up with the proverbial shoebox of receipts. I put a new roll of adding machine tape in the calculator and start plowing through. A half hour later I have a 18 foot tape but there's a problem...I only have about $4,000 of expenses accounted for. I bring it to the client's attention and he hands me a file folder stuffed with paperwork. I breath a sigh of relief but then I see what's inside. It's all EOBs (Explanation of Benefits) from his insurance company. Apparently the client included all of the charges that Blue Cross paid directly to the hospital...about $10,000.
I took a deep breath and explained that he can only deduct what he paid. Not what his insurance paid. He said he thought out-of-pocket included what came out of Blue Cross' pocket too. I shook my head and explained that he's going to have to pay back the taxes taken on the medical deduction. About $2,500 plus interest. I was able to talk the IRS out of penalizing the client 20% of the tax for accuracy but he was still on the hook for the tax and the interest.
So when we talk about out-of-pocket, I want to be clear that this has to be what you paid with your own funds or charged to a credit card.
The same goes for when I ask for unreimbursed expenses related to your job. If you get an allowance for tools, uniforms, travel, etc. you can't deduct it on your return. If you spend more than the allowance, then you get to deduct what you paid out-of-pocket.
I want every client to pay the lowest possible tax every year. But as this unfortunate client discovered, when the your number is pulled in the audit lottery you better have the records to back it up. Oh, and it helps to know the definition of out-of-pocket.