Help! I'm Being Audited: Are My Professional Fees Deductible?

When a taxpayer receives an audit notice from a taxing authority he or she should seek immediate professional assistance. Dealing with an audit is a complex process and a trained professional can assist you in avoiding many common pitfalls.

While hiring a tax professional to assist in your audit defense can be costly, in many cases, the fees paid can be deducted on your tax return. The nature of the deduction can depend upon what tax item(s) are being audited. In general, professional fees that relate to producing or collecting taxable income or receiving tax advice are deductible.

Individual Tax Audits

Audits of individuals can range in scope from a cursory look at a particular item of income or deduction to an intensive review of all items included in a return. This latter type of audit relates primarily to employed individuals and covers income and deduction items such as wages, pensions, mortgage interest, charitable contributions and medical expense deductions. In general, professional expenses associated with defending this type of audit are deductible as a miscellaneous itemized deduction on Schedule A of a tax return. It is important to note that to benefit from this deduction the taxpayer must itemize his or her deductions and the amount of all such deductions must exceed 2% of the taxpayer's adjusted gross income (AGI). Also, this deduction is not allowed to the extent that the taxpayer is subject to the dreaded alternative minimum tax (AMT) regime.

Self-Employed Individual Tax Audits

A self-employed individual who files as a "sole proprietor" will include a Schedule C in his or her tax return. Schedule C income/loss can also arise from activities through a single member limited liability company (LLC). Schedule C audits are very common especially if there is a resultant loss. Professional fees incurred defending an audit of this activity are deductible in full as an ordinary and necessary business expense. This is, of course, a much more favorable tax treatment than an employed person's miscellaneous itemized deduction. A Schedule C deduction does not depend on whether the taxpayer itemizes, nor is it limited in any material way. Additionally, it results in a reduction of AGI which may favorably affect other items on the tax return. The Schedule C deduction is also allowable under the AMT taxing regime and will benefit taxpayers subject to this tax.

Taxpayers often organize their business activities through partnerships or S...