Monday, February 1, 2010

Bed buffaloes in our tax audit

Here are the bed buffaloes that led to our audit:

Bed buffalo #1: New York State tax law does not allow the same number of deductions for exemptions as federal tax law.

While taxpayers are allowed to claim deductions for both personal exemptions and dependent exemptions on their federal tax return, the State of New York now only permits taxpayers to claim deductions for dependent exemptions. (Apparently, there was some distant time in the past, prior to 1988, when New Yorkers could claim personal exemptions for themselves as well as dependent exemptions for their dependents, just as they do on their federal returns, but no more. I can't for the life of me understand why the NYS Legislature decided to create trouble and confusion for taxpayers by deciding to change the definition of allowed exemptions back in 1988 so that it no longer aligned with the federal definition, but I guess we are stuck with that bed buffalo. Changing it back to conform with the federal definition would likely only cause more confusion at a time when state tax administration resources are already stretched thin! And our state legislature is even more notoriously dysfunctional now than in the past. In any case, we only moved to New York in 1989, and so our family has always known we could only claim our dependents as exemptions on our NYS returns.)

The NYS Tax Department folk are very aware that this is confusing for some folks, and every year they highlight this distinction, both on the tax form and in the accompanying instructions.

This is understandably confusing for many New York taxpayers and errors are quite common, especially for taxpayers who do their returns by hand. It's quite understandable that many taxpayers might reason: "I claimed four exemptions on my federal return and so I get to claim four exemptions on my state return," even though the New York instructions say otherwise. (This is not too surprising--life is short and the tax instruction manuals are long, and only tax policy wonks like me actually think they make interesting reading! Actually, I don't find the instructions especially interesting reading, but I do feel compelled to read them, since I want to keep my family AND our VITA taxpayers out of tax trouble!)

Bottom line: So the maximum number of exemptions we were eligible to claim on our 2006 federal return was four (two personal exemptions for my husband and myself and two dependent exemptions for our daughters.) The maximum number of exemptions we could claim on our 2006 state return was only two (just for our two daughters--none were allowed for ourselves.

We did not exceed those limits. So why does New York think we made a mistake in claiming our two daughters on our New York return?

Read on more for more bed buffaloes.

Bed Buffalo #2: Federal tax law provides that parents may decline to claim a dependent child on their federal tax return in order to allow that child to claim education credits on their own federal return.

We had done exactly that. Our income was too high to claim the education credits on our federal return, so by declining to claim our older daughter on our federal return, we enabled her to claim the education credit on her federal return. We did lose the value of her dependency exemption on our return, but due to dependent exemption phaseout provisions in the tax code (another bed buffalo in the tax code I won't go into here), that exemption wasn't actually worth all that much money to us.

Discussing this strategy gives me an opportunity to comment on a tangentially related bed buffalo that can gore the unwary.

Bed Buffalo #3: Declining to claim dependents that you could have claimed on your return does NOT, under current tax law, allow those dependents to claim their own personal exemptions on their returns!

A taxpayer who CAN be claimed by another taxpayer as a dependent may NOT claim a personal exemption for herself, even if that taxpayer entitled to claim her declines to claim her.

I knew that, of course, so I made sure to keep my daughter from being gored by that particular bed buffalo, but many people do not realize this.

Okay, enough on that side note, our family successfully dodged that bed buffalo. Back to the consequences for our New York return.

Yet another bed buffalo!

Bed Buffalo #4: Even though we had chosen not to claim our daughter on our federal return, New York State still allowed us to claim her on our NYS tax return.

I remember discovering this particular bed buffalo back in 2006, finding it somewhat surprising at the time. I had initially assumed that choosing not to claim her on our federal return would preclude claiming her on our state return, but page 94 of the 2006 NY Income Tax Instructions reads:

If you were entitled to claim a dependent on your federal return but chose not to in order to allow your dependent to claim the federal education credit on his or her federal tax return, you may still claim him or her as a dependent on your New York return.

(Conveniently those 2006 instructions are still available available online. In fact for the obsessively curious or very delinquent late filers, instructions are still available on-line going all the way back to 1985!)

So, I followed the instructions and did exactly what the worksheet on page 94 told us we could do: claim dependency deductions for both daughters on our New York return even though we had only claimed one of them on our federal return.

As far as I can tell, we followed the tax instructions correctly to the letter, but we still got ensnared in an audit triggered precisely by the discrepancy between the one dependent claimed on our federal return and the two dependents claimed on our New York return.

Why? Because the New York State tax forms did not--and still do not--provide any place where the taxpayers can explain why the number of dependents they claim on their state return exceeds the number of dependents that they claimed on their federal return.

Since New York State tax authorities are understandably diving into the sofa cushions for much needed tax revenues, they recently obtained a datatape from the IRS allowing them to compare the total number of exemptions claimed on 2006 federal returns (in our case that number was 3, my husband, myself, and our younger daughter) with the total number of exemptions claimed on 2006 NYS returns (in our case that number was 2, just our two daughters.)

Most of the people swept up in that comparison net were people who had been gored by Bed Buffalo #1 above, people who wrongly claimed personal exemptions themselves and/or their spouses on their NY returns, due to confusion with the federal rules.

Some of the people who successfully navigated Bed Buffaloes #1, #2, and #4, may find that when they mail in their required explanation, that the tax authorities will realize their dependent child was actually gored by Bed Buffalo #3, which could result in additional money owed by the dependent child, on her federal and/or state returns, if s/he wrongly claimed a personal exemption for herself.

I believe our family has successfully navigated around all the Bed Buffaloes listed above, but I need to call the NYS tax department folks to find out exactly what documents we should provide to prove this to their satisfaction.

Stay tuned for more.

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