Avoiding Financial Disaster: Case Study #1

A friend of mine, who I'll call Maxine, recently experienced some setbacks in her financial life. It all started after she landed her first job and tax time rolled around. Not being interested in doing her own taxes, she hooked up with an accountant who had been recommended by several friends for slashing their tax bills.

Taxes? We don't need no stinking taxes!

Maxine was thrilled with this accountant. Although most people who don't own a home have very few tax writeoffs, she racked up $12,000 in deductions for things such as clothes, a computer, and entertainment expenses. But unbeknownst to Maxine, these deductions weren't even remotely legal.

The accountant was justifying all the deductions as being necessary expenses for her job. True, self-employed people in certain fields can claim deductions for these things, when they're a necessary part of business. But as an employee, Maxine couldn't legitimately claim them as job-related expenses unless they were specifically required by her employer. And when she got audited, that's exactly what the IRS wanted to see: letters from her employer saying she was required to buy those things. Not being able to furnish these letters, Maxine had to pay up, with interest and penalties.

What you don't know can hurt you

It was a harsh lesson that what you don't know can hurt you. After all, it was Maxine who had to pay the interest and penalties, not the accountant. Even though the accountant was the one who knew the deductions were illegal, she was able to get off scot-free. Today, she continues to bring in new clients from referrals (presumably, from those who haven't been audited yet).

So what can be done about this? How can someone know when an expert is wrong? We need to keep in mind that if something sounds too good to be true, it probably is. For example, if you're an employee who doesn't own a home, but you still have enough deductions to itemize, that should be a red flag. Having said that, some things seem too good to be true, but in fact they are true. So ask around and get other people's opinions. I'm sure that there are plenty of people out there who would have been very suspicious of that accountant, even if some of her friends recommended her. So if you get conflicting opinions, do your homework and decide who you should believe.

Not out of the woods yet

After Maxine settled up with the IRS to the tune of $4,000, she stopped using that accountant and got a friend to do her taxes with TurboTax, using the standard deduction. She thought it was all behind her. But then there was the matter of state taxes.

She recently got a letter from the Georgia Department of Revenue, saying they had been informed by the IRS that her federal income tax return had been adjusted. They wanted $2,200 in underpaid state taxes, plus $1,300 in interest and penalties. Ouch!

The bill from the IRS had been a huge blow, but getting the bill from Georgia was much worse. She literally couldn't pay this bill, and could only think that she'd have to give up the life she wanted and move back in with her parents. She was devastated.

However, there was good news in this case. Although she's a Georgia resident now, she was a Florida resident for the year in question, so she owed absolutely no tax to Georgia. I felt bad having to tell her that it would probably be an annoying mess to clean up, but she said the fact that it was a mistake was such a huge relief that she couldn't even explain.

What's the lesson here? People in a position of authority are not infallible. Sending a state tax bill to someone who clearly was not a resident of that state at the time was a careless mistake. If you ever find yourself having to pay for something that doesn't make sense, doesn't seem right, or could even possibly be wrong, ask around.