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Seven lessons learned from a tax-preparation nightmare

A tax preparer and his client paid the price for deducting unreasonable expenses to get more money back

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When you hang around a bunch of accountants long enough, you're bound to hear stories of crazy tax deductions – many of which don't pass muster with the taxman. There are stories of taxpayers trying to claim a dog as a dependant, or trying to write off a daughter's wedding as a business entertainment expense. Last fall, an employee went to court over some disallowed deductions. He was ultimately on the hook for thousands of taxes he initially avoided. There's a lot to be learned by his case.

The story

The taxpayer, Mr. K, was a salesperson at a well-known electronics store in Ontario. His earnings were primarily from commissions on sales. In 2007, he reported $44,781 of employment income and claimed expenses of $26,571, amounting to 59 per cent of his employment income. He claimed a refund of all the taxes that had been deducted from his pay that year. In 2008, he reported employment income of $45,623 and expenses of $25,012 (55 per cent of his employment income). In addition, he claimed a rental loss of $9,241 in 2008. For 2008, he once again claimed a refund of all the taxes deducted from his pay that year.

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Now, it's no secret that our tax law doesn't provide employees with many available deductions, although commissioned sales people have some flexibility. You can deduct reasonable expenses incurred to earn commission income if you're required by your contract of employment to pay those costs and you were ordinarily required to carry on your employment duties away from your employer's workplace.

A key problem, in Mr. K's case, is that his tax preparer was very, very aggressive. He met his tax preparer through friends at work who also used him to file their returns. The tax preparer deducted the cost of a used car purchased by Mr. K (a car is a capital asset to be depreciated for tax purposes, not deducted all at once), the cost of mutual fund purchases (how is this an employment expense?), traffic tickets (fines such as this aren't deductible), home Internet and satellite costs (personal expenses), and almost $4,700 for non-existent expenses, including $2,884 claimed for "boots and gloves," which were not required by his contract of employment, and so on. You get the picture. (As an aside, Mr. K's tax preparer was subsequently sentenced to house arrest for failing to report $524,000 of his own income between 2006 and 2009.)

At the end of the day, Mr. K was denied virtually all his employment deductions and the rental loss. In addition, he faced gross negligence penalties.

The lessons

1. Choose your tax preparer carefully. Not all tax preparers need to have a professional designation, but a Chartered Professional Accountant (CPA) is bound by strict rules of conduct, which reduces the likelihood you'll face the problems of an incompetent or unethical tax preparer.

2. Big refunds should raise questions. You might be legitimately entitled to a large refund. But if you like your tax preparer because he or she gets you large refunds, make sure you understand why you're entitled to a large refund.

3. Understand your tax return. The judge in Mr. K's case stated that, "While taxpayers are not expected to be tax experts, they are expected to make a reasonable effort at ensuring the accuracy of their return."

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4. Don't be a lemming. Just because some friends use the same tax preparer, don't let that convince you that all is well and that you should use the same preparer.

5. Ensure your preparer is identified on the return. Mr. K's tax preparer deliberately left his name off page four of the tax return. This should be a red flag if your preparer does the same.

6. Be sure your employer signs an accurate T2200. You may be entitled to employment deductions, but only if your contract of employment requires you to pay for certain costs. Your employer needs to sign Form T2200 as proof of this. Mr. K presented more than one version of a signed T2200 to the court, and each was contradictory. Very confusing.

7. Avoid wilful blindness. Gross negligence penalties can apply if two conditions are met: 1) There must be a false statement in your tax return (Mr. K met this condition), and 2) you must have knowingly, or under circumstances amounting to gross negligence, made, or participated in, assented to or acquiesced in the making of, a false statement. This includes "wilful blindness" – that is, looking the other way when you should be asking questions about your tax return. Mr. K didn't ask questions when he should have. Don't make the same mistake.

Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author and founder of WaterStreet Family Offices.

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