… and Taxes
Every year, Americans pay millions of dollars in extra tax. Because they are concerned about or fearful of an audit, they decline to claim deductions they are fully and legally entitled to. This is the Fear Tax.
Because I write a lot about our own tax minimization efforts… (Yeah… sorry about that :/ ) I get more than my fair share of commentary in this regard:
“The IRS is coming for you, man!”
“OMG!!! You are going to get audited!!!! Ahhhhhh……!!!!!”
It’s totally worth it though, because I’ve learned a great deal and saved big dollars as a result. But also because these conversations often lead to great discussions about tax law, ethics, fairness, government accountability, and civic responsibility.
Maybe we can have another one of those helpful discussions…? This time, about the Fear Tax.
The Fear Tax
There is no reason for the IRS to be a warm and cuddly organization. A reputation for cold and callous behavior helps ensure respect and compliance. Even the language used in the law is somewhat terse and threatening:
26 U.S. Code § 7201 – Attempt to evade or defeat tax
Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.
And then there are the big news stories about famous people suffering the government’s wrath:
“Because of the IRS, Al Capone rotted in jail, suffering from syphilitic delusions!”
The syphilis probably wasn’t the fault of the IRS… but Al Capone did have millions of dollars in income that was never disclosed on tax returns. That is tax evasion. Don’t do that. (Also, don’t kill people.)
“But Pete Rose spent months in jail and had to pay $366,042.86 in back taxes and penalties!”
Sure, he intentionally and knowingly filed false tax returns. That is tax fraud. Don’t do that either.
The Dreaded Audit
What exactly is this audit thing that people are afraid of? According to the IRS itself:
An IRS audit is a review/examination of an organization’s or individual’s accounts and financial information to ensure information is reported correctly according to the tax laws and to verify the reported amount of tax is correct.
In English: people look at your tax return and see it if appears normal and makes sense.
There isn’t anything terribly concerning about having the IRS look at your tax return. After all, isn’t that why we sent it to them?
The IRS will audit a few tax returns randomly, and others that just look weird. For example, it wouldn’t make sense for somebody making $25k/year to have $100k in mortgage interest deductions.
In our case, we’ve already had over 100,000 people review/examine out tax returns (2013, 2014, 2015.) What are a few more?
Besides, what are the odds?
How Likely is an Audit?
The likelihood of an audit is extremely low. In the words of some guy on Forbes:
…statistically speaking, you have a better chance of being abducted by aliens or dating Taylor Swift than being audited.
I don’t want to crush the dreams of you big time T-Swift fans, but that means never. In FY’15, only 0.7% of returns were audited.
Reviewing the data by Adjusted Gross Income is even more interesting:
(Data from 2015 IRS data book.)
Low income and 1%ers are most likely to be audited. On one extreme, the IRS is probably curious how you managed to buy groceries and pay rent if you had no income last year. On the other extreme, if you made bank you probably had a complicated tax return… and these returns are likely to provide the biggest return per audit hour.
For Schedule C / E filers, the odds increase.. more complicated returns are more prone to error, but the odds are still less in the range of “once in a lifetime.”
But if you are abducted by aliens… how bad is the probing?
Penalties and Interest
I’ve been audited 3 times that I can remember. (Sorry TayTay, I’m not interested.) Each time was a minor inconvenience and a great educational opportunity.
All of my audits were Correspondence Audits (done by mail.) I received a letter asking for clarification, supporting documents, or money. I replied with the information and/or dollars requested, and that was that.
In one case, I even got an additional refund. Another time, I was asked to pay some back taxes, penalties, and interest. (Sometimes math is hard. Oops.)
Generally speaking, there are 3 main situations where penalties will be applied:
- Failure to file – you didn’t file your tax return by the due date (incidentally, if the IRS owes you money you can wait up to 3 years to file…)
- Failure to pay – you didn’t pay all tax due. This can go hand-in-hand with failure to file.
- Accuracy-related – this applies if you were negligent; disregarded the rules; made a substantial understatement; claimed a tax benefit for a transaction that lacked economic substance; or made a foreign financial understatement.
Not filing a return or filing late can result in penalties of up to 25% of tax due, although there is potential leniency for cases where there is a clear inability to pay.
Accuracy related penalties can be more severe; up to 40% of tax due. Interest charges may also apply (currently only ~3%.)
Those sound like big numbers, and they are, but note some key words that are missing… nowhere does it say “big penalties because this guy claimed deductions to which he was fully and legally entitled.”
No, penalties are for people who “don’t pay their taxes”, “don’t file their taxes”, and “do a crap job on their taxes.”
It is easy to not be one of those people.
How Much Tax To Pay?
But how much tax should we pay? What deductions are we fully and legally entitled to?
Well… all of them. They exist in law because you are expected to claim them.
OK, but isn’t trying to minimize our tax burden illegal, or maybe an ethical gray area?
It turns out the United States Supreme Court took some time out of their busy schedule to answer for us:
The legal right of an individual to decrease the amount of what would otherwise be his taxes or altogether avoid them, by means which the law permits, cannot be doubted.
That sounds very clear to me, but maybe you are looking for an answer from a higher power than the SCOTUS?
In that case, I refer you to JL Collins (author of The Simple Path to Wealth) who shared this in a comment on another post:
Many, many years ago, when I still owned rentals, I had a tax accountant who prepared my returns. His philosophy: “If you are not being audited, you are not taking enough deductions.”
Indeed, every year he did my taxes I was audited. Most times I had to pay a bit more, but overall far less than if we’d been less aggressive.
I was amazed at what the IRS was willing to accept even when they had us under the microscope.
…
If you are committing fraud, yeah the IRS is something to be feared. And, as you are shifting your burden to me, I hope they get you.
But if you are aggressively seeking every deduction you are untitled to, while you may have some quibbles to resolve, the IRS is not there to punish you.
Summary
The US Treasury received millions of extra dollars every year because people decline to claim deductions to which they are fully and legally entitled, out of fear of an audit. This is the fear tax.
US tax law and the IRS should be respected, yes. But feared, no. As long as we do our taxes in good faith, and timely and honestly report our full income, there is little to be concerned about. The stories of jail and big fines are about people who forgot that bit about honesty.
Sometimes we make innocent mistakes, and that is OK. That might result in some small penalties and interest, but over the years this will be much less than the guaranteed penalty of the Fear Tax.
So go ahead, claim those deductions. History, probability, the US Supreme Court, and the law are on your side.
NOTE: I’m just a random guy on the Internet who has no idea what he is doing. Tax laws change periodically, and you should consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice, is not a substitute for tax advice, and could just be wrong :)
Like with many fears, the less you know, the more scary it is. Thanks for sharing your stories and shedding some light on the boogie man :)
I think there is an Emerson quote… Knowledge is the cure for fear (or something like that.)
I have done my own taxes for decades now. Do I take all the deductions that I possibly can? Absolutely. It is the right of every American to pay as little in taxes as they are legally obligated to. Don’t fear the reaper, er, IRS.
You are doing it exactly right.
I trust turbotax to be on my side, to be both fair AND help me claim the deductions I’m allowed. So far, so good, and I could see that failing to claim some legit deductions can result in thousands of dollars added tax…
Turbotax is great.
As someone who works for a corporation and gets bimonthly paychecks and an annual performance bonus, rents an apartment, doesn’t own a car, and maxes his 401k, IRA, and HSA, what are some potential deductions I could look into that I may be missing?
You are doing great by maxing out all 3 accounts! Unfortunately, there is little to nothing else you can do. But if you have side hustles (e.g. a blog) then you can potentially deduct expenses like your laptop and home office.
Thank you for this post. I’m tired of this kind of legal behavior being labeled as “shady scheming” or dishonest. It’s unfortunate that our system is so complicated but to let fear rule you and always take the “it’s easier and safer” way is how you lose out on a lot of potentially life changing opportunities (e.g. Your retirement) and end up getting taken advantage of.
My pleasure
In talking to the IRS on a few occasions, they have no problem with aggressive LEGITIMATE tax deductions as long as you can justify them. Even if you mess up the typical penalty is 20% of underpayment plus interest. It makes perfect sense to get aggressive within legitimate limits of what you can justify under the tax code.
The wash sale rules are a good example of where I might push the limits. They haven’t really clarified what “substantially similar” means. Is the VOO SP500 fund from Vanguard “substantially similar” to the SPY fund from State Street or IVV from iShares? I’d say no because they trade differently, have different corporate structures, and don’t have identical assets, plus they have different costs and expense ratios. They are similar but not the same. I say that means they aren’t “substantially similar”. Don’t think it’s ever been litigated but I can’t see it making any sense to be overly conservative, so I have no problem selling one of the SP500 at a loss and immediately rotating into another similar (but not “substantially” similar) fund, which could include the Total US market funds or ETFs.
I don’t think substantially similar has been litigated, but I’ve never had to mess with a gray area there as I’m usually selling to adjust the asset allocation anyway.
Totally agree on aggressive and legitimate.
I have certainly paid the fear tax. Last year we transitioned from a large house to a townhouse and donated many many MANY car loads of stuff to Goodwill. I took pictures but didn’t take notes and we claimed none of it on our taxes because of fear of an audit. With our home paid off we don’t foresee any deductions in the future but have missed opportunities for sure.
Donations are definitely a deduction to which you are fully and legally entitled.
But big picture… Paid off house! Congrats!
Thanks! Selling the house meant we hit FI so it’s all good. ?
This is awesome! The kid of self-employed people, I grew up living in fear of the IRS. My mom told me that being audited could cause a nervous breakdown because of the stress, but I’m thinking that whoever she knew who was audited just kept bad records, was disorganized or had something to hide (lying is stressful). Hubby and I are self-employed and we pay through the nose (even with 7 kids!!) each year. I’m thinking we aren’t being aggressive enough.
7 kids! Those are some nice personal exemptions and child tax credits!
and yet. We cut a check to Uncle Sam for $23K. I’m thinking we’re not being aggressive enough! Hubby and I both have businesses with low overhead (I’m a blogger, he’s in furniture repair). This year we’re buying a house, so we’ll have that interest to deduct at least.
Low overhead businesses are great. After all, a deduction just means you spent a whole dollar on something and got a few pennies back on taxes. Better to have the dollar.
Here are some tax reduction ideas that I would evaluate:
Unless you had septuplets recently, some of those kids are old enough to contribute to the family businesses. Put em to work! 7 kids * 6.3k = 44k/year tax free.
All of your work equipment… laptops, power tools, work van, etc… should be expensed or at least depreciated.
Each business should have a solo 401k… contributions come straight off the top so reduce your most heavily taxed income. (Contribution limits are up to $53k/year each, subject to income requirements.)
Maybe the new house has room for a dedicated work space for a home office. Or maybe there is a separate shed dedicated to furniture repair.
I also have a couple blog posts coming with other ideas.
I think you can pay the fear tax on a lot more than just taxes, too. Not knowing the details and being afraid of what could happen leads to overpaying on all sorts of things (insurance comes to mind first). And, as usual, being more knowledgeable will save you money!
The Ignorance Tax and the Fear Tax are first cousins.
This year, for the first time, I hired a tax professional to help me with my taxes. Why? Because I fucked up big time with some offshore money (yes, yes, I am badass like that. I have ‘offshore accounts’. Sigh. Ok. No, not really. They are just investments that I made when I worked for 8 years in another country before I immigrated here). I had (unintentionally) defrauded the IRS. During my first meeting with the tax folks I was nearly in tears. “I don’t want to go to jail for being an idiot” I gibbered. It turns out the IRS has a provision for idiots. I had to file under a program known as SDOP. There were many forms to be filled, but one stands out. It was the “I’m sorry I was so very very stupid” form. I wrote all about this illuminating experience on my blog. What were the main things I learned?
1. The tax professionals I worked with were very casual about audits (oh we get a ton of those requests every day. no biggie.).
2. They were unafraid of the IRS (You messed up? Well here is how we will fix that and you must pay the IRS all of this money that you owe. In the next breath: now lets look at ways in which you have been paying them too much. If we’re giving them some money, it is only fair that we get some refunds).
3. The IRS is interested in criminal wrongdoing and in going after people who are intentionally defrauding them. They are not after the likes of me.
I wish there was an idiot form for more things in life. I could definitely use one of those.
If there were, I would have used up all the forms long before you got there…
They used to have a form, but they couldn’t print them fast enough…
Had I known you were going to use that quote, I’d have spent more time crafting it. ;)
Another thing about those audits. I was both scared and interested the first time I received the notice. These were field audits (appear in person at the IRS office) and I was curious to go. But my accountant wouldn’t let me, and his appearance was all that was required. His reason:
If they asked a question he wanted time to answer, he could just say “I’ll need to check with Mr. Collins.”
If I was sitting there, they’d say, “Go ahead. We sit here and listen.” :)
I like your accountants more and more :)
I thought your quote was perfect just the way it was. Also, thanks for submitting the personal photo for the intro ;)
I paid a fear tax for 2015. A former employer (whom I left early in 2015) reported a particular fringe benefit as wages, in a way which I didn’t agree with. But after some time trying to get the employer to change it, trying to contact the IRS for guidance, and asking strangers on the internet, I decided to interpret it conservatively and pay the tax. I already wasted my time trying to avoid $250 of excess tax; further time seemed to be just going down the drain. It would be trivial for the IRS computers to notice the wages on my 1040 were lower than the sum of my W-2s and send me a bill. So I paid the fear tax and chalked it up to valuing my time. I did not calculate the value time I have now spent whining about my experience.
Some things aren’t worth the time. This sounds like one of them, wise choice.
Interesting. I’ve been audited by correspondence at the state level for a math error but never federal. All said and done the difference was only a few bucks. Other then a request for more money and an acknowledgement it was resolved that was the end of it. It’s good to hear federal is much the same. I would never avoid a deduction to avoid audit risk, don’t be flagrant and you should be fine.
I deal with the CRA but I definitely like the idea of “if you’re not being audited, you’re not deducting enough”. I definitely haven’t utilised my deductions enough the past times I filed but I’m excited to put my new financial savvyness to use this upcoming tax season.
Love it GCC!
I have this friend who hasn’t filed his taxes in many many years (10 years probably?). You know what? Nothing Ever Happens! He keeps on doing it year after year. He spends every penny too. His thinking is, if he doesn’t have any money, the IRS can’t take anything when the time comes.
I don’t agree with his strategy, but he’s a great example of someone who *really* doesn’t fear the IRS.
Nothing ever happens, until it does. They can garnish future wages and social security, and even take your freedom.
I would welcome an audit. It’s a chance to discuss whether the calculations were correct. If they’re not, I’ll happily pay the extra money for my mistake. It’ll probably turn into a great article.
As for the fear tax, I’m not sure if that’s actually what’s going on. There was a report this year that the IRS lost $458 billion in revenue between 2008 and 2010 due to tax evasion. They pegged compliance (on the basis of tax dollars paid vs tax dollars owed) at 81.7%. So if there is a fear tax, some people may be paying it, but it’s a net negative tax!
Net negative doesn’t matter if you personally are paying too much tax.
I take all the deductions and credits I’m entitled to (that I’m aware of). I received a letter from the IRS when I was fresh out of college as they didn’t think I earned my tuition tax credit of $2,500. In the letter they asked me to send them the $2,500 plus interest. Of course I didn’t do that. I sent them a copy of my transcript and proof of payment of tuition and poof, their claim went away.
Another audit passed with flying colors.
Admittedly, I think I’m one of those folks that pay the fear tax. I have a ton of side hustles going on, but just don’t take many deductions on them even though I probably should be more aggressive with my deductions.
Currently facing the fear tax with my Airbnb income. I set a high threshold for when Airbnb pays me. Thus, I haven’t received any income for stays that have occurred in 2016, even though I do have a right to that income. My hope was that I could defer that income into 2017, but the more I read up on it, the more I think that I can’t do that, because my Airbnb income might be considered as constructively received under IRS regulations.
I seem to get mixed responses when I ask people whether I can defer this income into 2017. But I probably just won’t take the risk.
Will it matter? You expect much lower income next year?
Well,,,,yea. I kind of feel like you wrote this for me ;) I have definitely paid the fear tax – especially with our rental properties and not deducting enough each year. I don’t claim the small percentage for our “home office” and I’ll be nervous about claiming my blog as a business now too… But I think I could handle an audit. As Biglaw Investor said, it would be good to see what I’m doing wrong and I have paperwork to back things up. I just trust that Turbotax “low audit risk” right now – but I will try to make sure I take everything I can this year.
I did write it for you, of course ;)
Great post. I believe that many many people also pay a “fear tax” in that they feel they must pay an accountant to help them avoid dealing with a fear tax.
Tax software and, gasp!, old school paper tax returns are something that most people should try and grow comfortable with.
This is a great point. The accountant fee is a fear tax for many, but could also be an education expense if done correctly.
As a sanity check, I did my most complicated tax returns ever by myself using TurboTax and in the subsequent year had a tax accountant review it while preparing my current year’s tax return. Everything checked out and I haven’t gone back to an accountant ever since.
We paid the naive tax back in 1999. Had just relocated to the US and our tax advisor applied to much of our relocation expenses as deductions. The IRS did not like it. And my company basically passed the buck to me despite them providing nebulous and ambiguous paperwork on the relocation costs stuff. Our accountant represented us and along with a groveling letter from me, we only had to pay a small amount of interest and they waived any penalties. Turned out the IRS can be nice. Sometimes.
This is a good example… as long as you have a reasonable explanation for why you did something, things work out. It is also a good educational opportunity.
I guess this is one reason I never did my own taxes… I always paid an accountant because I was too scared of forgetting a deduction or doing something wrong but I want to try to file myself this year :)
I know I am paying a bit of “fear tax” because I can’t find a model/guidance for the situation. So far the tax hasn’t been significant enough to invest in a professional answer. But, if anyone has a model tax return for a US Citizen residing in a foreign that deducts tax paid to the foreign country for things like Dividends, please let me know!
Just to clarify the risk, your chance of an audit is less than the chance of dating Taylor Swift, correct? Were it the odds that if you date her, she will write a song about you after the break up, that would be reason for fear!
Excellent point EE
Thanks so much for this, exactly what I needed at this time as I’m learning about taking deductions.
Thanks for adding so much value to the lifelong students of wealth.
I definitely try to avoid the Fear Tax. The only time I tend to overpay is when I don’t have sufficient documentation to support a deduction, even if it is legitimate. For example, I never get a receipt when I make a donation to Goodwill because I don’t want to wait around while they itemize the box of random junk I dropped off (and potentially reject some items). I still take the deduction, but usually less than I probably could.
I also got audited once (although it was just a letter from the IRS asking about a couple specific things, so I’m not sure that counts as an audit). It was very straightforward and I didn’t end up owing anything. It turned out to be very satisfying when they admitted I didn’t actually owe them $5,000.
A letter from the IRS is a correspondence audit. Welcome to audit survivors anonymous.
My own Goodwill donations went similarly, although you can just take a picture of the stuff you donated and use that as a “receipt.”
This is a great post, thanks for the reminder. Quite a few years ago, I made an honest mistake on my taxes that resulted in me underpaying on some dividends. I was terrified when I got the audit letter. To my surprise, when I called in to find out what I needed to do, everyone I worked with was completely relaxed, happy to point me in the right direction to recalculate correctly, and in general very pleasant and helpful. I’m sure it didn’t hurt that even with penalty I ended up owing less than $100, but it was actually a great experience as I not only learned something, but am now much less afraid of the whole processes.
So the IRS can be warm and cuddly :)
Thanks for addressing this topic! I once commented on a financial forum that my real federal tax rate was less than 5% because of planned deductions, and another commenter responded that people like me should be ashamed that we “don’t pay our fair share”. I couldn’t believe that she felt a moral obligation NOT to minimize her tax burden. WTF?
I still play a game each year to see how low I can get the income taxes – both as a percentage of gross income and then as a percentage of net worth. I track progress against the previous year, and actually look forward to tax season for this reason!
I like to ask those people to send in a special donation to the US Treasury.
It always amazes me that people get upset with how others use our tax laws to their benefit.
The only thing I left on the table is the home office, but that’s because we can’t claim it. The space is also the kid’s bedroom… Other than that, I’m claiming as much as I could. We’re already paying plenty of taxes because I’m self employed.
If you can’t claim it you can’t claim it… even a screened off corner would be enough, but maybe too small to be worth the effort.
Another great post. I have a somewhat related question about filing US taxes from abroad. My wife and I will soon be filing our first US tax return from abroad and were unsure which mailing address to list on our tax return. Which address do you list on your US tax form? Do you use your Traveling Mailbox address? Do you use an international address? Thanks for the help!
Best, Scott
This will be the first year I’ve been using the Traveling Mailbox service during tax season, but that is the address I will use.
Great reminder here that one of the most powerful ways governments control their citizens is through fear. Not that I’m trying to come off like some anarchist – but it’s true. Governments and politicians rely on people being afraid and not understanding how the system works. As always – thanks for helping to spread some knowledge and open some eyes!
I think this fear is universal. Part of it comes from ignorance I think. Most people, including me, prefer not to deal with all this tax stuff. I do it as I view it a necessary evil but most people want to know as little as possible about the whole subject.
Another part comes from people either living paycheck to paycheck (and not being able to handle a fine or having to ‘suddenly’ pay more) or really wanting to avoid negative financial surprises (same reason why a lot of people do not do stock investing, they cannot handle the down years).
What is sure is that an entire industries have evolved around this ignorance/fear profiting very well off them. Which is probably one of the reasons tax systems in most countries are needlessly complex ….