Disallowed. A tale of a small taxpayer and a Kentucky tax notice
July 27, 2023
By Miranda L. Simpson, CPA
The Kentucky Department of Revenue (KYDOR) frequently sends out notices to taxpayers that they owe additional taxes because a particular expense or itemized deduction has been disallowed, for example. This is a frustrating practice for tax professionals and taxpayers alike for many reasons; mainly because it is often more cost effective for our clients to pay the tax than pay our fees to protest or respond to these notices. It is the reality we all know and live by, as does the KYDOR.
Every now and then though, as tax professionals, we may come across a case and determine that the cost/benefit is worth the fight. I personally experienced this recently when one of my clients received a notice from the KYDOR. I prepared to persevere and “go the distance” like I wrote about in my article a few years ago when I related being a taxpayer advocate to stepping in a boxing ring. But, spoiler alert, a quick knockout in the first round was all it took to win this battle. Read on to learn about the case and how to handle similar notices when your clients inevitably receive them.
“Is this even a legitimate business?” was the question I was asked by the representative that answered the call I made in April to the KYDOR. My clients were due a refund from Kentucky but after a couple of months passed by without receiving it, they asked me to call and check on the funds since the KYDOR usually sends a refund within eight weeks from the filing date. When I called, I was transferred to a representative who told me that my clients’ refund was not sent because there was an adjustment to their return resulting in a tax liability instead. Initially I questioned whether my client paid all their estimated payments correctly (as is often an issue). But no, as the representative explained, my clients’ ENTIRE Schedule C expenses had been disallowed, hence the question about the legitimacy of the business. The only other information provided by this phone call was a fax number and mailing address if we chose to send a copy of every single receipt and canceled check for the business. If we decided to fax or mail the documents, the KYDOR would review them within 60 days to determine if they were “legitimate” or not. In the meantime, interest and penalties would be accruing on the additional tax assessed.
Frankly the conversation alone was alarming. Since when does the KYDOR get to decide that a business is not legitimate based on a single tax filing? This is especially troublesome considering the accusation was made without even the courtesy of an audit or at least asking questions first. In my clients’ case, the business reported a net loss on the tax filing, but it was the first year of operations and we elected to take accelerated depreciation on a few asset purchases. Nothing was out of the ordinary as compared to many other small business tax returns in the first year or two.
Over the years I have seen similar notices other clients have received. Typically, there are small categories of expenses “disallowed” such as charitable contributions or property taxes. But never have I witnessed a case where 100 percent of a business’ expenses were disallowed without an explanation as to why or a reason an issue was flagged.
Within a few days after my phone call to the KYDOR, my clients received the notice that read as follows:
The Schedule C expenses claimed on your return have been disallowed. You may submit verification of these expenses by providing canceled checks or receipts that detail the business purpose of each expense claimed.
Further down on the notice was the promised tax assessment that, in the grand scheme was not a significant amount of money. My client even suggested just paying the tax and moving on with life, as is usually the advice I would give. I reminded him of the refund he was due and thus combined with the tax liability would make for a nice donation to the KYDOR, if he was so inclined.
Ultimately, we decided to formally protest the notice in writing, if for nothing more than to stand up for what is a right and fair process for taxpayers. For reference, below is a generic version of the letter we wrote to protest the notice. Feel free to use this as a template if your clients receive a similar notice but tweak the details as necessary for your specific client’s facts and circumstances.
Department of Revenue
Station Number 56
501 High Street
P.O. Box 1190
Frankfort, KY 40602-1190
May 2, 2023
RE: Protest – Case number XXXXXXXXX
Tax: Individual Income Tax
Tax Period: 12/31/2022
Taxpayers: Mr. & Mrs. Small Taxpayers
SSNs: XXX-XX-XXXX; XXX-XX-XXXX
Dear Taxpayer Assistance Representative:
We are writing to protest the notice dated 04.15.2023; relevant details of the notice are mentioned above. A copy of the notice is also enclosed for your convenience.
The notice indicates our Schedule C expenses have been disallowed and that we may submit verification of these expenses by mail. In the meantime, the Department of Revenue has assessed additional tax due without the courtesy of reviewing the expenses or allowing us and our CPA to discuss with an auditor. Further, we believe the Department of Revenue is reaching beyond their powers to disallow these expenses and has no basis for doing so without more explanation or, as a result of an audit.
The business is established with the Kentucky Secretary of State as a Limited Liability Company and has filed quarterly sales tax returns, and Form 725 as a single member LLC, as it is required. The 2022 tax year was the first year of operations and therefore incurred more expenses than revenue. We also took advantage of accelerated depreciation on a few asset purchases, as we are entitled.
We are happy to have an auditor review the receipts and canceled checks with our CPA at her office or a location convenient for the auditor. Otherwise, we believe this notice, and the cumbersome request to make copies of every single receipt and mail to your office (while holding on to our refund and demanding payment), to be abusive and unnecessarily punitive to Kentucky small business taxpayers.
In response, please contact and copy our CPA:
Taxpayer Advocate, CPA
123 Concerned Taxpayer Avenue
The Bluegrass State, KY 40XXX
Mr. & Mrs. Small Taxpayer
As I alluded to in the beginning of this article, luckily this case came to an end very quickly. Within two weeks of sending the protest my clients received a follow up notice in the mail with the very short and sweet message:
Tax notice is withdrawn. The business expenses are allowed as claimed.
A few more days after receiving the second notice, my clients received their refund check in the mail.
Although this is a great victory for the profession and a happy ending for my client, shining light on the bigger issue of this practice by the KYDOR is the purpose of this article. The quick turnaround and reversal of the disallowed expenses, when called out, is indicative to me that it should not have happened in the first place. Taxpayers have the right to defend themselves and at the very least be given the opportunity to prove their expenses with an audit. As my fellow CPAs know, unlike in criminal cases, there is not a presumption of innocence in the tax world. Taxpayers shoulder the burden of proof if questioned or audited.
If you need additional assistance to resolve a taxpayer issue, the Kentucky Society of CPAs also has resources to help. Contact P. Anthony Allen, the Government Affairs Director, to reach out to government officials within the KYDOR.
About the author: Miranda L. Simpson, CPA, can be reached at firstname.lastname@example.org. Simpson is a self-employed CPA with extensive experience in tax. She has authored many federal tax articles for The Kentucky CPA Journal.
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